Foreign Firms in China

From The Practice September/October 2016
Looking beyond the hype

Globalization seems to be getting a bad rap these days. Between Brexit and the rising unpopularity of free trade in the United States, it appears that the push for more open borders may not be as easy, or as inevitable, as many once predicted. This uncertain path of international expansion has also been true for foreign law firms in China. As an economic juggernaut, China represents enormous possibilities for international law firms eager to expand into new markets. But the country’s strict national regulations continue to prevent foreign firms from achieving both their desired positions in the marketplace and the accompanying profits.

Building off Sida Liu’s lead article on the rise of Big Law in China, this article examines the history and current state of foreign law firms in the Chinese legal market. In some ways, the story is one of miraculous development. Before the 1990s, there were no international law firms in China to speak of. Today, more than 170 have offices in mainland China. But this astounding growth belies the heavy regulations and restrictions that continue to prevent these firms from truly flourishing. By drawing on recent scholarship on the subject, as well as interviews with leading practitioners, this article seeks to separate the reality from the hype.

To understand the position of international law firms in mainland China, one has to first appreciate the relative infancy of the modern Chinese legal profession. While there is no question that China now has a robust and growing community of lawyers—which, as Liu argues, has manifested itself in a unique ecosystem—one of the most distinctive markings of this community is its relative youth. The Chinese government now often takes a protective stance toward its lawyers, but it hasn’t been that long since it persecuted the community into near extinction. Beginning with the Communist revolution of 1949, the government of the People’s Republic of China took a suspicious if not outright hostile attitude toward the country’s lawyers, who were viewed as a potential threat to the absolute rule of the party. This stance took on new intensity with the Cultural Revolution (1966–1976), during which law schools were shuttered and lawyers condemned and persecuted as rightists and antirevolutionary.

Today, more than 170 have offices in mainland China. But this astounding growth belies the heavy regulations and restrictions that continue to prevent these firms from truly flourishing.

In the post-Mao era, under the leadership of Deng Xiaoping, the government attempted to rehabilitate the country’s legal profession, recognizing it as critical to the government’s reform agenda. The government reopened and established law schools throughout the country and passed regulation to stimulate growth and expansion of the legal profession. In 1980 there were almost no law graduates; by the end of the decade, there were roughly 12,000. By 2010, this number had grown to more than 200,000 and law had become one of the most popular majors in Chinese universities.

Although these numbers indicate a profound growth in the absolute number of lawyers, one should not confuse numbers with the creation of a robust legal profession. In fact, scholars observed that the state-run effort to educate more lawyers resulted in too many lawyers for an economy and a society not equipped to employ them. Like their counterparts in the United States, many new graduates of Chinese law schools found themselves with low job prospects.

In addition, the relative newness of the profession meant that Chinese law firms often lacked the institutional depth required to make them competitive against foreign firms as places of employment—at least that tended to be the perception. Thus, even as China began to open up its economy to the world, the government ultimately maintained a largely protectionist approach to its community of legal professionals. It wasn’t until the end of the 1980s that international firms were able to establish a foothold in China, and even then they had to do so under the guise of being “business representatives.” Jingzhou Tao, who is currently a managing partner for Asian practice at Dechert LLP, was involved in the early days of foreign law firms in China. As Tao describes, foreign law firms were an “open secret” as the Chinese government did not officially recognize their work but still taxed them. While Tao officially worked for the New York–based law firm of Coudert Brothers, he and his colleagues had to play a game of pretend. In an interview with The Practice, Tao explains:

I was supposedly chief representative of Johnson & Hagen, an insurance broker. One of my colleagues in the same office was chief representative of Brunswick Bowling, the bowling company. We had to register with the government as the chief representatives of these companies, and they know that we don’t do anything for those companies but render legal service.

In 1992 the Ministry of Justice officially allowed international law firms to open offices in China, but heavy restrictions continued to severely limit their ability to compete with Chinese firms. Even as China has increasingly opened up its markets through its accession to the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO), the state continues to strongly regulate the legal market.

Today, international firms still face a number of restrictions to their operations in mainland China:

  • Foreign lawyers may not sit for the Chinese bar exam or practice Chinese law.
  • Chinese lawyers hired by international firms must suspend their license to practice law during employment.
  • Foreign lawyers are restricted from engaging or interacting with certain PRC government agencies.
  • Foreign firms face a burdensome and time-consuming registration process for opening a representative office, including a three-year waiting period in between opening offices.
  • Foreign firms are taxed at a much higher rate than domestic firms.

As Rachel Stern and Su Li have observed in their work on foreign law firms in China as part of the Center on the Legal Profession’s Globalization, Lawyers, and Emerging Economies (GLEE) research project, protectionism is most likely a core cause of these restrictions.

China’s lawyers entered the 21st century newly liberated from the state payroll and self-conscious about their skills. Sheltering the nascent bar from international competition, at least temporarily, was a way to give Chinese lawyers breathing space to learn about cross-border commercial law and how to run a law firm. In fact, a good number of developing countries have similar regulations in place. In Brazil, much like China, foreign lawyers are limited to practicing international law or the law of their home country. The explosive growth of Chinese law firms over the past decade suggests this strategy worked.

As Stern and Li note, China is not alone in restricting the activities of foreign law firms. Indeed, India has even more-restrictive measures than China or Brazil, banning foreign lawyers from operating in the country all together. There are indications, however, that the Modi government may be ready to open up many of these restrictions.

In addition to protectionist concerns, Stern and Li also argue that the motivation behind these strict regulations could be authoritarian in nature. As the current crackdown against human rights lawyers in China suggests, the Chinese government continues to be wary of the relationship between the legal community and agitation for political change. It thus should be no surprise that they would be doubly suspicious of U.S. or Western European firms, which might be viewed as potential bastions of liberalism and democratization.

Narrow space or niche market?

Whether rooted in protectionism or fear of Western influence, these regulations have ultimately created a narrow space within which foreign firms can operate in China. Barred from litigation services, most firms find themselves helping Chinese and U.S. clients with matters such as mergers and acquisitions, technology transfer, intellectual property, and Foreign Corrupt Practices Act (FCPA) compliance. While the rates of foreign firms are often more expensive than Chinese firms, they are able to leverage more than just their top-quality lawyers. For foreign companies wary about the reach of the Chinese state, foreign firms seem like a safer bet for ensuring attorney-client privilege: rightfully or wrongfully, many foreign companies still remain skeptical of whether or not Chinese lawyers may be vulnerable to government pressure for information. For Chinese companies and state-owned enterprises (SOEs), the decision to hire a foreign law firm may partially stem from a desire to demonstrate their equality with other global corporations. While the narrow field has allowed some firms to develop a niche in the Chinese legal landscape, it has ultimately hindered their growth and profitability, particularly as Chinese firms continue to grow in both size and sophistication. Tao, who has the vantage point of having worked for a foreign firm in China, explains this shifting landscape.

In the 1990s our work concentrated on the inbound investment projects. At that time, Chinese law firms were limited in knowledge in dealing with foreign companies directly, and foreign companies had limited knowledge about Chinese law firms. You can trust people only when you have had past dealings with them, so foreign law firms were able to monopolize these kinds of inbound investments. Since then, however, more Chinese law firms have become familiar with foreign direct investment and this type of work has become commoditized. Moreover, foreign companies are becoming more familiar with Chinese law firms and are developing in-country, in-house legal teams. Both this in-house work and Chinese law firm work took away quite some of the traditional legal work of foreign law firms.

As the work has changed, so has the makeup of the Chinese offices of foreign law firms. In particular, Tao believes that the model has changed from one of “dispatching” from the home office to “localization.”

In the old days, the home office would dispatch some lawyers, American or British, to work in China. Those lawyers would have an elementary skill in Chinese, but their knowledge in the local laws and the local political, economic, and cultural background was very limited. They were a bit handicapped, as they weren’t integrated in the local community.

Tao goes on:

Today, the typical profile would be a Chinese national who graduated from one of the top law schools in China, eventually studied abroad in the United States, England, or continental Europe, and gained working experience in that country and who comes back to work in firms such as Dechert LLP. In essence, you now have quite a high degree of localization of lawyers versus dispatching somebody from the head office to China.

While foreign firms are doing their best to thrive despite the regulation and new competition from domestic players, it remains to be seen just how long they can fight with one hand tied behind their back.

Outpost office

As a result of these limitations, foreign firms are adopting strategies to maintain a presence in mainland China while minimizing expense. As Stern and Li’s extensive research of the business practices of foreign firms has revealed, one model for these firms appears to be dominant: the outpost office. Their research reveals that the median size of international law firm offices in mainland China (in 2013) was 11 lawyers, and 60 percent of law firms had no more than 19 lawyers. They also found a strong, positive correlation between the firm size and the time spent in the country, global presence, and percentage of partners of Chinese descent. In other words, the largest offices in China tended to be those with the longest tenures in China, those with the largest global footprint, and those whose partners are of Chinese descent and are therefore presumably positioned to navigate China’s cultural and language barriers.

Number of International Law Firms in China by Year (1992–2012) Data compiled from MoJ lists published between 1992 and 2013.
Number of International Law Firms in China by Year (1992–2012) Data compiled from MoJ lists published between 1992 and 2013. Source: Stern and Li.

While the size of a firm’s China office is one way to assess its commitment to the region, profitability may be even more important. And when it comes to profitability numbers, a startling picture arises. In short, Stern and Li’s research found that China outpost offices are responsible for grossing only 5 percent of the firm’s global income. And while the data on the profitability of these firms is limited and it is difficult to directly link any particular transaction to the presence of an outpost office or not, Stern and Li note that whatever business that is directly generated by these offices is most likely not covering the costs of operating them. Indeed, in addition to the increased tax burden international firms face, the temptation to rent office spaces that are commensurate with their high-end brand is costly. Add to this the need to lower fees to compete with the more than 19,000 Chinese firms, and it becomes easy to see why foreign firms’ outpost offices in mainland China may not be able to run a profit. As Stern and Li state:

Instead of building a roster of long-term Chinese clients, law firms often find their prices undercut by competitors anxious to put together a blue-chip deal list. The big SOEs “could get all their legal work done for free,” one partner said. At SOEs that report to the central government, price wars are institutionalized through the requirement that several law firms bid for every sizable job. Though mandating multiple bids is designed to combat corruption, lawyers say the procurement department’s “horse and pony show” depresses prices.

As the outpost office struggles to bring in more money, it becomes more difficult for them to make a case for expansion. Partners in the home country offices might be willing to maintain an overseas office, but they may not be interested in increasing hiring for an operation whose contribution to the global revenue is so low.

China outpost offices are responsible for grossing only 5 percent of the firm’s global income, according to Stern and Li’s research.

Sticking it out

As Stern and Li’s research has shown, very few international firms have made the decision to close up shop and exit China, despite the apparent lack of profitability. Overall, the decision to both enter and stay within the Chinese legal market, despite indicators that it may not be a good business strategy, seems to boil down to three factors. First, firms believe that international outposts make for good optics. The term “global” has become synonymous with sophistication and market dominance, so many firms can be convinced that the China outpost office pays for itself merely in the positive press it brings to the firm. This “dot on the map strategy,” as Stern and Li refer to it, reflects the circular nature of globalization discourse, whereby clients and providers are each convinced that being “global” is both the proof of and the means for success.

Second, many international law firms have a blind faith that opening an operation in China, more so than any other emerging legal market, is bound to eventually pay off. Stern and Li contend that international law firms, which generally conduct little market research, are easily convinced by the hype peddled by economists regarding China’s booming economy and just assume they would be fools to ignore this market. Even after it becomes clear that the operations may not be lucrative, belief in the eventuality of profit from the Chinese legal market may prevent firms from jumping ship.

The term “global” has become synonymous with sophistication and market dominance, so many firms can be convinced that the China outpost office pays for itself merely in the positive press it brings to the firm.

Finally, in addition to the optics and the hype, there is the issue of sunk costs. Once firms have gone through the considerable cost, time, and effort required to set up shop in China, it becomes increasingly difficult to cut bait. With the promise of huge profits always around the corner, and the fear of having to start over at the back of the line, firms are willing to continue to wait it out. The outpost office allows the firms to take a bet on China paying off without risking a tremendous amount of resources in the process. And, as Stern and Li point out, the fact that so many firms are deciding to stay both normalizes the decision and intensifies the belief that leaving prematurely would prove to be disadvantageous. After all, no one wants to be the first to shout that the emperor has no clothes.

In the end, law firms eager to penetrate the Chinese market should carefully consider the value and costs (at least those that can be assessed) of such a decision. Like all business forecasts, they should also be prepared for anticipated costs and values to change. Firm leaders should be cognizant of trends within the global legal community but cautious of making decisions based on groupthink or “FOMO.” While all markets are fickle, the legal market can be particularly so, given its location at the intersection of politics and business. As law firms seek to expand their global presence in China and beyond, they should bear in mind that even a flattening world will bring its share of bumps.