E-commerce in China. How can you get a piece of the action? Summary. Introduction

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1 E-commerce in China How can you get a piece of the action? Summary On 19, Alibaba launched the largest IPO in US history, raising US$21.8bn on its debut on the New York Stock Exchange. The Chinese internet company, founded in 1999, was valued at US$170bn. With over 630m internet users as of July 2014 and online sales of over US$200bn in 2013, the economic possibilities for China s internet and e-commerce markets seem limitless. But, at the same time, China remains determined to shape the internet in line with its own vision and values. This briefing gives a snapshot of the latest regulatory trends towards foreign participation in the e-commerce and internet sector in China, and the potential opportunities for foreign companies. Introduction On 19, Alibaba raised US$21.8bn on its debut on the New York Stock Exchange, with a greenshoe option for the underwriters to raise the initial public offering to US$25bn. Alibaba ended its first day of trading with a market capitalisation greater than that of Facebook or Amazon and ebay combined. With over 630m internet users in China as of July 2014, the e-commerce market is vast. KPMG has forecast that e-commerce transactions in the country will reach as much as US$540bn by Nearly a third of Alibaba s overall gross merchanising value is accounted for by sales through mobile platforms, with that proportion set to grow. E-commerce has also been described as a uniquely social activity in China. Nearly half of all online shoppers read and post reviews about products, which is more than twice as many as in the US. The interactivity of social media provides consumers with an immediate feedback loop for advice and comment about products sold online. And Chinese social media platforms in turn have more advanced payment and e-commerce functions than are found elsewhere. For example, Tencent s WeChat platform, with more than 600m subscribers across Asia, integrates TenPay to enable payment for such things as restaurant bills and taxis, and even to make payments and obtain reimbursement from hospitals. Richard Bird T E [email protected] Chuan Sun T E [email protected] Victoria White T E [email protected] Against this backdrop, the PRC government has been making a concerted push towards developing the internet and e-commerce through policy statements such as the circular on the development of e-commerce in China, issued in February 2012, and the State Council s Opinions on the Construction and Development of Next Generation Networks, published in March Both of the policy documents put great emphasis on investment in internet infrastructure and other support for China s booming e-commerce industry. Freshfields Bruckhaus Deringer E-commerce in China how can you get a piece of the action? 1

2 Foreign investment controls in China All foreign investment in China must comply with the government s rules on which activities are encouraged, restricted and prohibited for foreign investment (under the Catalogue for Guiding Foreign Investment). The current catalogue (revised in 2011) opened the way for foreign investment in nextgeneration internet systems and services by listing a number of these activities among those encouraged and promoted for foreign investment. These include the development and manufacture of next-generation internet system equipment; software and chips (based on IPv6); outsourced information technology and business process services, including system application management, IT support management, financial settlement, software development and data processing services. The revised catalogue demonstrated the government s objective to accelerate the development of the internet and technology services industry and its intention to encourage foreign investment in the sector to achieve this. Telecommunications regulation in China a continuing constraint Foreign participation in a range of internet and e-commerce activities comes under China s far-reaching telecommunications regulation. Many non-facilities e-commerce services offered over the internet will be characterised as value added telecoms services (VATS) requiring a VATS licence from the Ministry of Industry and Information Technology (MIIT). While in theory foreign investment (up to a maximum 50 per cent foreign investment) is permitted for VATS businesses in China, in practice very few foreign invested enterprises have been granted VATS licences (and none for online activities). Instead, the now well-known variable interest entity structure (VIE structure) is widely used to support foreign participation in PRC e-commerce businesses. In a typical VIE structure, the foreign investor establishes a wholly foreign owned enterprise (WFOE) in China that effectively controls a local Chinese company through a series of contractual undertakings, share pledge agreements and call options rather than through ownership of shares. The local Chinese company, in turn, holds the necessary VATS licence and other permits for the business to operate in China. The VIE structure avoids the restrictions on foreign ownership because the WFOE or the foreign investor does not have a shareholding in the licence holder. The WFOE or its subsidiaries conduct the ancillary non-regulated parts of the business. Although the use of VIE structures appears to be broadly tolerated by the PRC government, their legality for VATS businesses is a gray area. The Ministry of Commerce (MofCom) s decision in August 2012 in its merger control review of Wal-Mart s proposed acquisition of a controlling stake in the online direct sales business of Yihaodian, the largest online supermarket in China, put the legality of the VIE structure into the spotlight. In its decision, MofCom instructed Wal-Mart not to participate in Yihaodian s VATS business through a VIE structure. The decision has been viewed as reflecting the government s disapproval of the use of VIE structures to evade the restrictions on foreign investment in e-commerce and other VATS businesses. The VIE structure certainly involves risks for investors, including the risk that the government authorities might potentially view the indirect ownership as an unapproved foreign investment in a restricted sector. In such a case, the VIE framework agreements may be deemed invalid and unenforceable in the Chinese courts. However, an overt ban on the use of VIE structures seems unlikely. Many of China s leading e-commerce companies have themselves used the VIE structure to access offshore financing and listing on foreign stock exchanges through overseas holding companies, including Alibaba. The MIIT has not to date made any moves on VATS similar to those of the People s Bank of China (PBC) in The PBC stipulated that foreign participation would not be allowed under the new licensing regime for third-party payment processing. Such a hard stance on e-commerce and other VATS activities seems unlikely in the short term given the destabilising effect this would have on such a key growth sector. 2

3 Following release of a MofCom Circular in August , MIIT no longer requires foreign companies and foreign-invested Chinese companies who operate a website selling only their own products to obtain a VATS licence. Foreign invested entities must still make an internet content provider (ICP) record filing with the MIIT if their website is hosted on a server located in China. The applicant for an ICP filing must be a Chinese entity that has a local address (this could be a WFOE). Foreign businesses that do not have a presence in China often engage their local Chinese business partners or hosting service providers to make the ICP filing on their behalf. The 2010 MofCom Circular also clarifies that existing FIE s established with a business licence that includes retail sales through bricks and mortar stores may also undertake online sales as an extension of the existing scope of business. Approval of newly-established FIEs with a business scope limited to online retail sales was at the same time been delegated down to provincial-level branches of MofCom. A VATS licence is still required for an e-commerce platform that is open to third party vendors to sell their products (e.g. an ebay or Amazon marketplace style site). The provision of internet services to third parties is also a VATS regulated activity requiring a licence. Foreign participation in VATS services in the Shanghai Free Trade Zone New regulations in the China (Shanghai) Pilot Free Trade Zone (SFTZ) offer a window of opportunity to international companies seeking to break into the Chinese VATS market. These regulations applicable within the SFTZ appear to relax restriction on foreign ownership of VATS businesses as well as lowering the capital requirements for establishing a VATS business and simplifying the approval process. The MIIT and the People s Government of Shanghai Municipality jointly published opinions on 6 January 2014 that open up five types of VATS business to WFOEs: online apps stores; online storage and forwarding services; call centre services; internet access services within SFTZ; and domestic multi-party communications services. Call centre services, internet access services and domestic multi-party communications services had previously been completely off-limits to foreign investment under the PRC Telecoms Regulations. The opinions also allow restricted foreign ownership (ie subject to approval) in two other types of VATS businesses: domestic internet virtual private network services, up to a 50 per cent cap ceiling on foreign ownership; and online data processing and transaction processing services operating e-commerce businesses, up to a 55 per cent ceiling on foreign ownership. To take advantage of these relaxations, the entities must be established in the SFTZ and have their service facilities located in the SFTZ. However, service provision can be nationwide (except for internet access services which may only be offered within the SFTZ). Certain key VATS services, however, are not covered within the expanded scope, and will remain closed to foreign participation (such as internet data centre services). The minimum registered capital required for a foreign-invested enterprise in the SFTZ has also been lowered, from RMB10m for a nationwide VATS business (including a VATS business that extends over more than one province, autonomous region or municipality) to RMB1m. 1 Circular of the MofCom General Office regarding Certain Issues in Approving and Administering Foreign Investments in Online Sales and Vendor Machine Sales, 19 August

4 The measures introduced by the MIIT on 15 April 2014 allow for a simplified approval process for obtaining a VATS licence in the SFTZ through the Shanghai Municipal Communications Administration Bureau (SCA). The current approval process outside the SFTZ is a two-stage process, under which the applicant first obtains pre-approval from MIIT at the national or provincial level, and then must obtain a further final approval from MIIT after establishment. The normal procedure takes around 5 months to complete. Under the measures for the SFTZ, the SCA is required to review and process the VATS licence application within a significantly shorter period of 60 days from receipt. The lifting of some of the restrictions around foreign ownership of VATS businesses in the SFTZ now allows international companies to genuinely consider establishing certain VATS operations in the PRC without the need to rely on uncertain VIE structures or depend on local Chinese partners. The scope of the VATS activities to which the new regulations apply is however limited. Internet service standards All foreign-invested or domestic internet service providers (ISPs) are subject to Provisions (on the Supervision of the Market Order of Information Services) introduced in December 2011 that prohibit certain harmful practices. Practices that are harmful to internet users, such as collecting, using or supplying the user s personal information to third parties without their consent, installing software or plug-ins on the user s computer without their consent, or repeatedly creating pop-ups on the user s screen after they have been closed, are also prohibited under the provisions. ISPs are required to maintain platforms that are compatible with those of other ISPs. These provisions are additional to the government s guidelines (Service Norms for E-Commerce Trading Platforms) issued in April Those set out basic rules for the operation of trading platforms and requirements relating to the collection and retention of data, the verification of users identities, and fair trading practices in general. The government s scrutiny of online commercial activities is intensifying. Earlier this year, the State Administration of Industry and Commerce (SAIC) brought in administrative measures for online trading that require any sellers of goods or services online, whether trading through their own website or a third party trading platform, to provide certain information to the public about themselves and to comply with particular business registration requirements. New guidelines from the SAIC came into effect in July this year that regulate the standard terms of online trading platforms standard contracts with their users. The guidelines set out the basic requirements for the contracts and prohibit online trading platform providers from excluding liability for certain causes of action and restricting certain rights of their users under the terms. Participants in this sector should be aware that the government is increasingly policing and taking action against ISPs and internet businesses for non-compliant behaviour. Additionally, ISPs face secondary liability for intellectual property rights infringement under the PRC Tort Law. An ISP may be held liable for damages that may occur after the ISP receives notice that it costs it hosts infringes another s intellectual property rights. The effect of this rule is illustrated by a decision of Shanghai 1st Intermediate People s Court in 2011 involving Taobao.com. TaoBao had repeatedly deleted infringing listings pursuant to take down notices that cited trade mark infringement. However the court held that it could have done more to stem the infringement by limiting access to the account of freezing it, and blocking the infringer from opening new sites. Taobao.com was found jointly liable for trade mark infringement for failing to take necessary the measures to stop it. The court ordered damages and costs against Taobao.com, demonstrating the increased liabilities of ISPs for the activities of their users. The PRC Network Dissemination Regulations (2006) provides a safe harbour for ISPs that only provide a platform for posting content without actual knowledge or justifiable reason to be aware of infringing content if they delete the content pursuant to take-down notices. 4

5 The enhanced responsibilities of ISPs for the activities of their users appear again in the National Copyright Administration s draft amendments to the PRC Copyright Law, released for public comment in March Under the draft law, ISPs would be held jointly liable for copyright infringement when they have been notified of an infringement but fail to promptly delete, block or disconnect the infringement. ISPs would also face joint liability when they know or should have known that internet users were using their network services to infringe copyright but fail to adopt the necessary measures to stop the infringement. However, ISPs that merely provide storage, search, connection and other technical internet services to users will not be required to proactively ascertain a user s rights to content. Data protection on the internet Although there is no comprehensive data privacy law in China at present, the telecommunications and internet services sector has several regulations in place that impose obligations on service providers collection, management and processing of personal information. In September 2013, MIIT brought into effect a regulation on personal information protection for telecoms and internet users that tracks the general requirements under the OECD Guidelines and European Directive 95/46. Service providers must consent to the collection and use of personal information, publish policies for the handling of personal information, do not collect excessive information in relation to the purpose of use, and implement proper security measures, such as firewalls and antivirus programs, the protect the personal information. The regulation has broad application and is considered to apply to any entity that provides information through the internet to users. The scope includes a wide range of commercial websites operated by businesses in China that collect information from users over the internet, including corporate website and e-commerce sites. Internet service providers must also comply with the government s public networks decision that regulates data privacy of personal data transmitted via public telecommunications networks in force as of December The decision requires network access providers and network service providers to request users to register for their services using their true names and personal details as a condition to providing the services. Network service providers are also required to keep records of incidents of illegal content transmission on their networks and to report these to the authorities. Additionally, the revisions to the Consumer Protection Law in April 2014 introduce a specific provision on customers personal information that requires businesses to inform customers about the use of their personal information (purpose, method and scope of collection and use) and obtain the consumers consent, as well as publishing their policies on collection and use of personal information. Conclusion The opportunities for new business in China s booming e-commerce sector are clearly enormous. But gaining access to what is one of China s most politically and culturally sensitive industries is not necessarily easy. Careful planning and assessment of risk is essential. freshfields.com This material is provided by the international law firm Freshfields Bruckhaus Deringer LLP (a limited liability partnership organised under the law of England and Wales) (the UK LLP) and the offices and associated entities of the UK LLP practising under the Freshfields Bruckhaus Deringer name in a number of jurisdictions, and Freshfields Bruckhaus Deringer US LLP, together referred to in the material as Freshfields. For regulatory information please refer to The UK LLP has offices or associated entities in Austria, Bahrain, Belgium, China, England, France, Germany, Hong Kong, Italy, Japan, the Netherlands, Russia, Singapore, Spain, the United Arab Emirates and Vietnam. Freshfields Bruckhaus Deringer US LLP has offices in New York City and Washington DC. This material is for general information only and is not intended to provide legal advice. Freshfields Bruckhaus Deringer llp,, 01821