Learn Mandarin: Chinese School - Rules may vex foreign operators

WORLD / Wall Street Journal Exclusive

Rules may vex foreign operators
By JASON DEAN (WSJ)
Updated: 2006-07-28 13:28

http://online.wsj.com/public/article/SB115402455406219387-HJnoEtl0vW_M8o6Fd
vES8guBdeU_20060804.html?mod=regionallinks

BEIJING -- New rules issued by China's telecommunications regulator could
create significant complications for foreign Internet companies operating
in China as well as for Chinese Internet companies listed overseas,
lawyers and analysts said.

Just how much the measures, unveiled this week by the Ministry of
Information Industry, will affect Internet companies in China could
depend largely on the level of enforcement, experts said. The rules
appear to target a complicated legal structure that has been widely used
for years to enable foreign investment in the Chinese Internet industry.

The new requirements come amid ballooning interest in the Internet in
China, which boasts more than 120 million users, the second largest such
population after that of the U.S. Google Inc. and Microsoft Corp.'s MSN
service each launched operations in China last year, joining other big
foreign Internet companies like Yahoo Inc. and eBay Inc. Numerous Chinese
Internet companies, such as portal Web site operators Netease.com Inc.
and Baidu.com Inc., have attracted foreign investors through listings on
the Nasdaq Stock Market.

The measures are aimed at strengthening control over foreign investment
in "value added telecom services," a category that includes search
engines and other Web sites. The rules require that local providers of
such services own the domain names and trademarks that they use in China
-- key pieces of intellectual property that are often controlled by
foreign affiliates or investors.

A Google spokeswoman said in an email: "We have been working closely with
the government agencies for some time and are following their direction
to ensure that the legal structure of our activities in China satisfy all
government laws and regulations."

Spokesmen for Netease and Baidu said they weren't aware of the new
regulations and couldn't comment.

It isn't clear exactly what prompted the new regulations, which were
contained in a notice posted Wednesday on the Ministry of Information
Industry Web site, titled "Notice on strengthening management of foreign
investment in operating value-added telecom services." A spokesman for
the ministry declined to comment.

But the growing foreign role in China's Internet sector in the past
several years has come at a time when the government is trying to tighten
its controls over the Web, and some analysts say the level of foreign
involvement has unnerved regulators.

The new measures are "a starting step" for the ministry, said a senior
researcher at a think tank affiliated with the ministry. The regulator is
concerned about the increase in foreign investors buying control of
Chinese Internet companies, a trend it expects to accelerate, he said.
"The MII is eager to bring things under control now," the researcher said.

Even so, the government has in the past issued tough-sounding new rules
that it then followed with relatively lax enforcement.

"The significance will depend on how the MII enforces this regulation,"
said Chen Jihong, a partner at ZhongLun W&D Law Firm in Beijing who
represents Internet company clients and who has examined the new
measures. "If they enforce it strictly I do think this will lead to a
significant change." He said affected companies might need to
substantially restructure their operations to continue operating.

Because China's laws limit direct foreign ownership of domestic companies
that provide Internet content and related services, Chinese Web-site
operators that want to sell shares overseas first establish a legal
entity offshore, such as in the Cayman Islands. That entity owns the
trademark, domain name, and other key intellectual property for the site.

The Chinese Internet-content provider license and related licenses,
meanwhile, are owned by one or more separate Chinese legal entities,
which themselves are often controlled by top executives of the offshore
companies but not by the companies themselves. The relationships between
these offshore companies and their local operating affiliates are
governed by contracts. Generally, the local operator collects revenue in
China from sales of online ads or other sources, which it passes on to
the offshore company in exchange for the license to use the trademarks,
domain names, and other intellectual property.

Lawyers say most or all foreign companies that operate in China or have
bought into local companies use similar legal structures, but their
arrangements generally aren't made public. Chinese Internet companies
that list overseas, however, must describe their structures in detail in
their regulatory filings.

Nasdaq-listed Baidu.com, a major Chinese search-engine operator, for
example, stated in the prospectus for its initial public offering last
year that it licenses its domain names, trademarks, and certain software
to a Chinese affiliate that is owned by two top Baidu executives. The
prospectus noted that there are "substantial uncertainties regarding the
interpretation and application" of China's laws, including those
"governing our business, or the enforcement and performance of our
contractual arrangements with our affiliated Chinese entity" and its
shareholders. Other Nasdaq-listed Chinese Internet companies like
Netease, Sohu.com Inc., and Sina Corp., describe similar arrangements in
their regulatory filings. Spokesmen for Sohu and Sina said they didn't
know about the new regulations and couldn't comment.

The MII notice said that "most" foreign investors have "strictly
observed" China's laws governing value-added services. "But," it said,
"recently, there have also been some foreign investors, using domain-name
licensing, trademark licensing and other means," in cooperation with
domestic companies, to "evade the demands" of the existing regulations
and "illegally operate value-added telecom business."

The new measures say that the trademarks and domain names for local Web
sites should be owned by the domestic operators themselves. The notice
also indicates that local operators should own the servers and other
infrastructure used to operate sites. It says value-added-service
companies already operating in China have until Nov. 1 to evaluate their
compliance with the new rules and report to the MII. Companies that fail
to comply with the rules can lose their license to operate.

Google ran into questions about its structure in China this year. In
February the MII said it was investigating the licensing of the U.S.
search-engine giant, which had recently launched a Chinese Web site. MII
didn't elaborate on the nature of the investigation, but local news
reports said it centered on whether Google had obtained proper licenses.

A Google spokeswoman said at the time that Google's partnership with
Ganji.com, a local Internet content provider, provided Google with the
required licenses.

New rules issued by China's telecom regulator may require foreign and
domestic companies operating in China's Internet industry to revise their
structures.

* Domain names used by Internet companies and other value added telecom
(VAT) providers must be owned by the local operators.

* Trademarks used by VAT providers must be owned by the local operator or
its shareholders.

* Applications for new VAT licenses that fail to meet the specified
requirements can be rejected.

* Existing VAT license holders whose structures don't comply with rules
could have their licenses withdrawn.

Sources: Ministry of Information Industry, China; ZhongLun W&D Law Firm

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