Opinion / China Watch

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

http://online.wsj.com/public/article/SB115402455406219387-HJnoEtl0vW_M8o6FdvES8guBdeU_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