Behind the high profile jostling between the US and China there have been some important legal changes with a potentially lasting impact, says Ken Dewoskin, senior advisor in Deloitte’s Chinese services group
Amidst the disruptions and confusions that characterise the current trade and investment frictions and negotiations between the US and China, there are some significant developments in law and regulation that are likely to have a sustained impact that outlasts the current headline issues and underscore what are arguably more intractable challenges in reaching a normal order for cross-border financial transactions.
Three factors are motivating legislative and regulatory changes. First both the US and China have broadened the scope of national security concerns, from the narrow focus on military and dual use technology to a broader definition of technology and other assets that contribute to competitiveness in key commercial and industrial sectors, enable control of supply chains and value added, and support global geopolitical influence.
Second, China's remarkable reform-era growth trajectory has promoted it to the world's second largest economy. Domestic campaigns such as the long-standing Going Out and more recent Belt and Road Initiative, as well as China's lead role in establishing the Asia Infrastructure Investment Bank (AIIB), have added to its widely recognised role as factory of the world a new role as banker to the world. And, although Chinese deal volume in 2018 fell by 40%, Mainland-based interests now control a significant portion of the world's non-bank financial assets, especially evident in registration centres like Luxembourg and the Caymans.
Up through 2016, China's outbound direct investment in real estate and technology assets was in very rapid ascent, and now control by Chinese individuals and enterprises of massive funds outside the Mainland make it difficult to determine how much offshore activity is ultimately for beneficiaries in China. But all developed economies are watching the impact of growing Chinese ownership.
Finally, innovations in IT-enabled financial services have permeated borders and revealed inadequacies of established regulations and regulators, whose authority remains based on the hard-edged borders of sovereign nations. While key international economic organisations and dominant national financial regulators have contributed to consensus in regulatory processes, like Know Your Customer (KYC) requirements and other anti-money laundering (AML) processes in formal banking channels, in reality myriad channels now exist to port very large capital tranches across borders without transparency. Major international banks have already implemented or are about to implement distributed ledger technology (DLT) on a massive scale for global FX transactions, internal transfers, digital contracts and letters of credit, and the like. DLT and cryptocurrencies are only the most obvious of these innovations but likely not the most material. Simply put, regulators remain largely bound by borders while financial services and transactions do not, and Asia, led by China, has emerged as a primary fintech player.
It is no surprise that new regulatory strategies are being sought to gain control over both visible financial services and what the Financial Stability Board defines as shadow banking. China and the US have legislated significant new laws and regulations to define and defend national interests while ostensibly contributing to improvement of global financial systems.
With regard to current negotiations, in the US, the headline issue with China has been trade imbalance, and that will remain so. The US trade deficit with China grew 17% to $323 billion in 2018. But arguably the more significant issue is technology protection, and that is what the most important new legislation in the US has addressed. In August, the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) became law, expanding the scope and role of the Committee on Foreign Investment in the United States (CFIUS), and in October the Department of the Treasury, which oversees CFIUS, issued details on the FIRRMA pilot program.
Also in October, China's National People's Congress passed the International Criminal Judicial Assistance Law (ICJAL), a piece of legislation that sets out a specific approval process for the use of any Mainland resources–data, witnesses and other evidence–that can be used in non-Mainland investigations, trials and remedies of financial crime.
Although starkly different regulatory thrusts, both of these initiatives should be on the radar of financial and legal executives.
CFIUS and FIRRMA
The US has been party to the 17 nation members of the Coordinating Committee for Multilateral Export Controls (CoCom) since shortly after the end of WWII. During the 1960s, legislation like the Arms Export Control Act gave the State Department authority to regulate US trade in arms and dual-use technology. Independently in the US, the CFIUS was established in 1975 to supervise the acquisition of technology assets in the US through mergers and acquisitions involving US assets.
The FIRRMA update, signed into law in August 2018, was the first update to CFIUS in over 40 years and expanded CFIUS authority in two ways. Previously focusing on acquisition of US business assets in the US that were specifically military or dual-use, the FIRRMA update authorises CFIUS to review activities anywhere in the world that involve such technology assets and their transfer. Second, FIRRMA expands the scope of what is included in national security, primarily to include technology beyond military and dual-use, technology that are termed "emerging and sensitive" and that are important for commercial competitiveness and geopolitical influence.
CFIUS operates under the US Department of Treasury with broad participation of other agencies in the US government. A pilot program announced by Treasury in October 2018 defined 27 industry sectors, including some in biotechnology, mobile electric power and natural language processing, for which any transfer of technology to a foreign party will require a formal declaration. In the aggregate, these represent expansion in the scope of national security and unprecedented detail on areas of interest. FIRRMA is early in implementation but the newly required declaration will be a sensitive document and likely the basis for a decision by CFIUS as to whether further examination of a particular transaction is warranted. While the changes mandated by FIRRMA are in the early stages of implementation and the documents do not specifically call out China, they coincide with and likely influence the significant drop-off in levels of inbound, technology-focused M&A from China through 2018 and into the present.
International Criminal Judicial Assistance Law
China's National People's Congress (NPC) passed ICJAL in October, a law that specified new, formal domestic approval processes as a requisite to providing information, evidence, witnesses, or any other form of support to criminal investigations by authorities outside of China.
This legislation essentially updates a bilateral agreement between China and the US signed in Beijing in June 2000. Article 1 of that agreement states: "In accordance with this Agreement, the Parties shall provide mutual assistance in investigations, in prosecutions, and in proceedings related to criminal matters". The most apparent change resulting from the new legislation is that it is not bilateral but broadly applicable to any investigation outside the Mainland. Implicitly, it sharpens the edge of enforcement.
Once a major regulatory decision is made in China, effected parties have little recourse
In introducing this, China's official media described it as facilitating cross-border assistance in criminal investigations by defining a consistent formal process. In contrast, some external experts examining the new law's articles see the new regulation as an effort to curtail assistance and make investigation of cross-border infractions, such as money laundering, securities fraud, FCPA violations, and embezzlement, more difficult.
Actual cross-border cooperation in implementation and enforcement of judicial decisions has existed for decades. In numerous cases of failed Chinese listings on US equity markets, critical information for investigations has flowed relatively freely without a visible approval process. Having said that, in some cases China has blocked specific information requests on the basis of "state secrets," and for the last decade, auditing working papers on the Mainland have been systematically withheld from outside regulator examination.
Recently there have been good examples of the previous agreement in action as it relates to implementation, with the US extraditing to China a subject of a Chinese criminal investigation, and Chinese courts enforcing a US civil judgement. That is not to say the process has always worked to the satisfaction of all parties. The perpetrator of a massive smuggling operation through the ports of Xiamen in the 1990s fled to Canada in 1999. He was finally extradited at Canada's request in 2011, 12 years after the process was initiated.
Balance points and the question of trust
Laws on trade and investment, as implemented, have the potential to enhance marketplace order and/or be protectionist. Between order and protectionism where the balance point rests might be less driven by financial calculations and more driven by political forces, domestic and international. In cross border relationships, the determinative factor is whether two parties view each other as co-operators or competitors. Behind the ubiquitous win-win rhetoric then, how national legislative initiatives actually are implemented rely on matters of trust.
It would be difficult to argue that trust has not been severely weakened between the so-called G-2, China and the US, as the trade war rolls on. Chinese media promotes the claim that the US is working to "contain" China's growth as a global economic and geopolitical major. The US media promotes the idea that China has nefariously failed to keep its promises, for example, in original commitments and dispute outcomes in the WTO. A weak level of trust has made the negotiation of verification processes a major topic in on-going negotiations. Both FIRRMA and ICJAL should be viewed in these terms, whether they will contribute to or impede a viable and reliable verification process.
Further, the behaviours that make reestablishment of trust challenging rest on a fundamental, cultural difference in the relationship between laws as written through a legislative process and the authority of regulators with respect to those laws. China does not recognize regulatory institutions independent of the ruling party. The judiciary, monetary authority, even the domestic security apparatus and army explicitly operate through authority delegated from the top Party leadership. Accordingly, regulatory behaviour is shaped more by the goals and ideal outcomes of current leadership than written code or judicial precedent. MNCs operating in China regularly observe that the written codes given them are vague, even when followed by implementation guidelines, and regulators regularly make decisions that seem contrary to their own regulations. Given that once a major regulatory decision is made in China, effected parties have little recourse. This leads to feelings that regulators are unpredictable, to say the very least.
A prolonged period of uncertainty
We have attempted to review two new legislative initiatives and a broad range of issues bearing on the future of investment relationships between the US and China, and by implication between other developed economies and China. The two legislative initiatives–one addressing prospective transactions with implications for sensitive and emerging technologies, the other addressing retroactively non-compliant investment activities–provide useful insight into future trends only when viewed in the broader context of historical events, current frictions, and significant cultural differences. This leads us to a view that even a successful resolution of the more acute trade and investment issues under negotiation currently will be a first step in a much longer process toward establishing a normal order in cross-border M&A and related financial transactions.
|About the author|
Kenneth J DeWoskin
Dr Kenneth DeWoskin is a former partner for China strategy and business development at one of the big four, founder of Deloitte's China Research and Insight Centre, and now serves as a senior advisor and eminence fellow to Deloitte for China research and insight. He concurrently serves as senior advisor to The Conference Board China Center for Economics and Business. A former professor of international business and chairman and professor of Asian cultures at the University of Michigan, Kenneth has been involved with China for over 50 years and has lived and worked extensively in both China and Japan.
Kenneth's direct experience with mainland China goes back to 1977. He has served numerous clients in financial and strategic investment, logistics, automotive and industrial sectors, and in the energy, telecommunications, consumer products, commodities and mining, retail, entertainment, media and IT, software, pharmaceutical and healthcare, and financial service industries.
Kenneth provides research and thought leadership and consults with c-suite executives on critical financial, economic, and business issues. His expertise has been sought by various institutions including Tsinghua University, Wharton, the New York Times, Financial Times, Economist, the World Economic Forum and others. He is a fluent speaker of Mandarin Chinese and Japanese.