Despite recent investor nervousness, there is no questioning the tremendous growth experienced by China internet sector. Statistics from the China Internet Network Information Centre show that China had 4m internet users and 9,906 websites at June 30, 1999, growing to 8.9m internet users and 15,153 websites at the end of last year.
The regulatory environment
A typical internet content provider (ICP) operation involves establishing a website to which the ICP provides contents and draws traffic. It may also involve the sale of advertising space, viewer databases, proprietary contents, software and technologies.
In China, the Catalogue for the Guidance of Foreign Investment Industries has established policy regarding foreign investment. The catalogue was approved by the State Council on December 29, 1997 and promulgated two days later by the State Planning Commission, the State Economic and Trade Commission and the Ministry of Foreign Trade and Economic Cooperation (Moftec).
The catalogue classifies industries into four categories: encouraged, type A restricted, type B restricted and prohibited. As the catalogue was composed in 1997, ICP is not specifically mentioned and neither can it fit neatly into any category of the catalogue.
As an alternative, we may examine some of the specific lines of goods and services that a typical ICP offers:
Selling proprietary software and technology
Information and communication system and network technologies are listed by the catalogue as encouraged industries.
Providing contents on-line
Printing and publishing are type B restricted industries, while news media is a prohibited industry. It should be noted, though, that only traditional media such as print, radio and television broadcasting are addressed in the catalogue.
Advertising is not listed in the catalogue. However, it is generally prohibited to set up a wholly foreign-owned enterprise (WFOE) in the service sector. There are, however, a few special zones and Shanghai Pudong New Area where WFOEs providing certain services prescribed by local governments can be established. At this stage, we are not aware of any ruling permitting the establishment of an advertising WFOE, and the setting up of a Sino-foreign joint venture advertising company is still very difficult in practice.
Under the Provisional Rules on the Management and Examination of the Telecommunication Business promulgated by the Ministry of Post and Telecommunications, the precursor of Ministry of Information Industry (MII), foreign investors are prohibited from providing telecoms services, including computer information services and e-mail box services. However, the provisional rules do not address ICPs, which only came on to the scene in 1995.
Relaxation in investment
Under the World Trade Organisation agreement reached in November 1999 between Chinese and US negotiators, foreign investment in ICPs is set to be liberated. In accordance with the agreement, foreign ownership is limited to 30 per cent upon China's accession to the WTO, 49 per cent after one year and 50 per cent after two years. For the time being, direct foreign investment in ICPs is disallowed.
MII officials recently stated that they are in the process of adopting new laws or regulations governing foreign investment in China's internet sector, including ICPs. The relevant laws or regulations are to be released soon.
In addition to Moftec or the MIT, investors also need to pay great attention to government agencies such as China Securities Regulatory Commission (CSRC) with regard to the future prospect of public listing. Since early this year, the CSRC has demanded that all over-seas listings of internet-related companies that have invested in foreign-investment enterprises registered with the State Administration for Industry and Commerce (SAIC) should obtain CSRC approval. In China, the SAIC is an agency that issues business licences for the operation of all legal entities, branches or representative offices, and it is also empowered to shut down illegal operations by revoking their business licences.
One of the most salient points with regard to the restriction of foreign investment in ICPs appears to be the issue of security. The State Bureau of Secrecy Protection announced in January 2000 that all organisations and individuals are forbidden from releasing, discussing or transferring state secret information on the internet, including bulletin boards, chat rooms or in internet news groups. Websites or organisations with computer links to the internet that fail to implement a control mechanism against security breaches could face shutdown of their sites or links to the internet.
The internet offers a new arena for various participants in e-business; it is no longer the big that snaps up the small, it is the fast that eats up the slow. China is a developing country where rules and regulations generally lag behind business practices. This may be viewed as an opportunity for some entrepreneurs, but a threat to those who are more risk averse. Many investors opt for penetrating into the market now, however, which is more relevant when we look at the industry leaders in this sector in various markets including China, most of whom are the ground-breakers.
Then, the question becomes, how can we craft a viable investment strategy given the current regulatory environment? We have cited two approaches ICPs adopt in structuring foreign investment ?the indirect and direct ownership approach.
To circumvent the legal ambiguity of investing in an ICP in China, some foreign investors may choose to hold the ICP and advertising operations through various homing and servicing agreements. Under tkis indirect approach, the foreign investor does not own equity interests in the ICP company or the advertising company. It derives fees from the ICP and advertising operations through business agreements.
A typical structure under this approach is to form an overseas company registered in a tax haven. The future listing plan needs to be considered in selecting the registration location of the listing vehicle as there may be some restriction.imposed by Nasdaq in New York or by Hong Kong's Growth Enterprise Market.
In order to carry out the advertising and ICP business in China, separate companies need to be established in China. The WFOE with the business scope to provide services may also need to be established in the structure.
Under this structure, the overseas company and/or the WFOE will enter into exclusive services and/or licensing agreements with the advertising company and the ICP company such that the overseas company and/or WFOE will be entitled to receive revenues generated by these two companies.
The advertising company, which can either be a joint venture or a local company, will be involved in designing, producing and publishing advertisements, while the ICP company publishes internet content. A WFOE directly owned by the listing vehicle may be established to provide technical sup-port and lease equipment to the ICP company in exchange for fee income under exclusive agreements. The WFOE also enters into agreements to provide the advertising company with consulting services related to the technical work on all advertisements. In addition, the advertising company also retains the listing vehicle as the exclusive advertising agent in the overseas market.
The listing vehicle may also be directly engaged in providing exclusive technical services and licensing intellectual property to the internet content provider company and/or to the advertising company.
One of the leading Chinese-focused inter-net companies with a portal in China that went public on Nasdaq in April 2000 adopts a similar approach as discussed above.
Investors may consider this structure if they are happy to tolerate indirect participation in the ICP operation. Nevertheless, a case-by-case CSRC approval must still be obtained in the listing process.
The direct ownership approach
While national-level agencies such as MII and CSRC address the macro concerns of foreign investment in the intemet sector, various local governments strive to meet their daily goals of encouraging foreign investment and developing high-technology industries in their locality.
In June 1999, internal guidelines were issued by Shanghai National Economic and Social Information Technology Leadership Group together with the Shanghai branch of Moftec that approves foreign investment projects. Under these internal guidelines, foreign investors may enter into Sino-foreign joint venture agreement in establishing ICPs provided an e-permit is issued by the local agencies in Shanghai for each proposed ICP project. However, the application will be subject to close examination and will be handled on a case-by-case basis.
Beside Shanghai, other localities may also adopt similar policies in granting per-mission to foreign investment in ICPs. How-ever, a green light from the local government on the ICP operation itself is no guarantee that the status of the current operation will not be reviewed once new laws or regulations are released to address the issue of foreign investment in ICPs, as some retail investors experienced in 1999. In addition, as CSRC approval is mandatory upon future overseas public listing, this local approach is only viable while the operation has no plans to list in the near term.
According to the Sino-US WTO agreement, foreign investment in ICPs will be liberalised gradually once China enters the WTO. Therefore, an indirect approach of operation may be converted into a direct investment approach in the future through merger and/or change of shareholding of entities in the current indirect structure. In the case of a direct approach, foreign owner-ship of the ICP operation may be increased subject to the ceiling established.
This article was written by Raymond Louie, partner, and Sandy Cheung, manager, of PricewaterhouseCoopers in Shanghai.