The Potential Impact Of Recent Changes In U.S. Trade Regulation On U.S. Investment In China - Caveat Emptor!

Monday, December 1, 2008 - 01:00

The past two years have brought ever-increasing growth in international trade in goods with China, and with that change have come significant developments in the esoteric world of trade regulation, culminating in important and potentially far-reaching changes in the application of U.S. trade law to China. While the antidumping law has assumed a fairly prominent role in international commerce as a weapon in fighting price competition from imports, the countervailing duty (CVD) law - aimed at countering subsidies provided by governments to particular industries - has fallen off the radar screen as subsidies have increasingly been reduced and eliminated worldwide. But increasing concerns about the U.S. trade deficit with China have resurrected the CVD law and complicated the investment climate in China, causing increased uncertainty for U.S. businesses investing in Chinese factories and other companies. This promises to make already complicated transactions in an admittedly Byzantine atmosphere all the more complex. The purpose of this article is to outline the dangers and potential pitfalls that a U.S. company may face from the competition back home when investing in China by reviewing one of the most hotly contested CVD investigations in recent history and one of the first of Chinese "subsidies."

The U.S. Government's Reversal Of A 20-Year-Old Policy

The most significant change in trade policy in recent years, both in substance and effect, has been the U.S. Department of Commerce's policy reversal of applying the U.S. CVD law to China. The CVD law concerns itself with the investigation of whether a foreign government provides "illegal" subsidies to domestic companies within a certain industry. At its most basic, subsidies are "illegal" (i.e., in violation of World Trade Organization rules and U.S. law) if they are limited to a certain industry or group of industries, either by reference to production or location, rather than generally available to all companies.

In the early 1980s when there was a spate of CVD cases filed against various steel products, Commerce determined that the application of CVD law to non-market economy countries was inappropriate because it was impossible to measure the extent of market distortions created by "subsidies" in a market that was inherently distorted by state planning and centralized control of production. Commerce followed this policy for more than 20 years. Partly in response to efforts in Congress to pass legislation requiring Commerce to apply the CVD law to China, in November 2006, Commerce initiated a China CVD investigation. This decision reversed Commerce's long-standing practice not to apply CVD law to non-market economy (NME) countries like China. Noting its historic refusal to apply the CVD law to China specifically because of its NME status, Commerce determined the Chinese economy had progressed sufficiently beyond the Soviet-style economic model of the Cold War era that subsidies could now be measured and an offsetting countervailing duty could be applied to offset the subsidy.

A mere 24 months later, Commerce has initiated 12 CVD investigations1 on a wide variety of products including steel pipe, magnets, off-the-road tires, thermal paper, kitchen appliance shelving, valves, sodium nitrite and citric acid, resulting in the imposition of CVD duties (in addition to normal customs duties) ranging from as little as two to as much as 600 percent.2 While many CVD problems cannot be anticipated, there are steps a U.S. company can take when investing in China. One particularly vulnerable situation that can be addressed is where a U.S. company acquires a Chinese company (either its assets or stock) and the new entity is subsequently the target of a U.S. CVD investigation; often subsidies received by the acquired company can be "imputed" to the new owners. Investors must, therefore, understand the impact of the CVD law on their acquisition of a Chinese company.

U.S. Investment In China: A Cautionary Tale

In the just-completed CVD investigation of off-the-road tires from China, Commerce illustrated the scope and breadth of the issue of subsidies in China and the devastating effect they could have on investment in China. In March 2006, a U.S. off-the-road tire (OTR) producer and marketer (Company) acquired the assets of a Chinese tire company. Some of those assets were in foreclosure under Chinese law. These assets, together with the remaining assets of the Chinese factory that were acquired pursuant to negotiations, were purchased at auction and used as the basis for the formation of Company's new Chinese subsidiary (Subsidiary). Prior to negotiating the acquisition, Company commissioned financial and legal due diligence studies and evaluated the market value of the assets it sought to acquire. Ultimately, Company was the only bidder. All required documentation was submitted to the local government and the sale of the assets to Company was approved at a price nearly equal to the valuation studies. The former Chinese tire factory, located in a remote and underdeveloped small city in the northeast, was in a serious state of disrepair, and Company was required to invest millions of dollars in refurbishing and replacing much of the acquired production assets subsequent to the purchase to make the facility useable. Subsidiary soon began producing and shipping OTR to the United States.

In July 2007, Commerce initiated a CVD investigation of OTR from China and chose Subsidiary as a respondent in the investigation. Commerce's investigation addressed subsidies received in 2006 and any one-time (i.e., non-recurring) subsidies received since 2001 whose benefit accrued over time (such as grants or debt forgiveness). As a newly formed, wholly foreign-owned enterprise, Subsidiary had little concern with Commerce's investigation of subsidies received in 2006. The investigation of non-recurring subsidies, however, from 2001 to 2006, proved problematic since under the CVD law a change in ownership triggers an in-depth investigation into whether any non-recurring subsidies received by the previous entity (the Chinese factory) "pass-through" to benefit the new company (Subsidiary), thus increasing its CVD rate.

To rebut a "pass-through" finding, a company must prove that the purchase of substantially all of the prior company's assets or stock was (1) at arm's length, and (2) for fair market value. A determination of whether a transaction occurs at arm's length seems innocuous and simple enough. The real battle is in establishing fair market value, a battle made all the more perplexing in a non-market economy setting. Commerce first determines whether the transaction was between two private companies or whether the Chinese government either owned or controlled the seller. In a "private-to-private" transaction, Commerce is generally more lenient and more likely to find the transaction at fair market value if appraisals and evidence of negotiations exist since Commerce presumes private companies to be profit maximizers. But in the case of a privatization (i.e., a "government-to-private" transaction), Commerce applies a more stringent test to determine fair market value because a government is not presumed to be a profit maximizer - a fact it must establish. To establish this, Commerce requires that a government establish that there was (1) an appraisal that was relied on in determining the price, (2) a public auction with a sale to the highest bidder, and (3) pre-conditions on the transaction to prove that the government acted in a profit-maximizing manner.

In the OTR case, despite the fact that the transaction followed the letter of Chinese law, Commerce found the transaction was neither at arm's length nor for fair market value. Commerce found the Chinese factory and Subsidiary to be affiliated through a mind-bending stretch of unique circumstances that are too technical and extraordinary to be fully explained here, resulting in the conclusion that the transaction was not at arm's length. In finding that the transaction was not at fair market value, Commerce focused on two issues: first, the Chinese factory's perceived relationship with the government; and second, the fact that there were lingering procedural issues that had yet to be completed from the company's 2001 Chinese privatization. Commerce essentially considered the company to be controlled by the government (even though it was owned by Chinese individuals) and therefore applied the more stringent government-to-private fair market value analysis. While Commerce questioned whether the parties actually relied on the appraisal in setting the purchase price (one of Commerce's requirements) since the appraisal was completed only days prior to the signing of the purchase agreement, it was also suspicious of the fact that only one bidder took part in the auction.

The punch line?: In finding the transaction not at fair market value or arm's length, Commerce calculated Subsidiary's CVD rate to include the rate from Chinese factory's non-recurring subsidies (i.e., several large, unsatisfied legacy loans deemed forgiven). That is, Commerce found these subsidies were not extinguished when the Chinese factory's assets (where the benefit resided) were transferred to Subsidiary and, thus, continued to benefit Subsidiary. Subsidiary's two percent CVD rate was thereby increased sixfold!

Lessons Learned: Knowledge, Perception And Preparation

It is important to recognize that Commerce's change-in-ownership analysis is very fact specific. While there are no surefire ways to avoid the kind of negative result described above, there are three simple lessons one can take away from this example: knowledge, perception and preparation.

First, the simple knowledge that CVD investigations against China are now reality and that subsidies can be passed through to a new investor in a Chinese company should influence how a company structures its investments. The application of Commerce's factors for determining fair market value in China can be unpredictable and, thus, problematic. But knowledge both of Commerce's CVD practice and Chinese business practices should influence decisions when one is considering investments in China, particularly in acquiring Chinese companies or their assets given the prevalence of questionable financial transactions in old state-owned companies.

The second lesson - perception is half the battle. Commerce's analysis in the OTR case was based as much on perception as on actual facts. Appearance as much as what actually transpires will be of interest and set the tone for the investigation. In the OTR case, though the transaction was "by-the-book," Commerce's knowledge of Chinese business practices combined with the perceived suspicious nature of the timing and circumstances of the asset purchase led to a finding that the transaction was not at fair market value.

Finally there is preparation. U.S. companies investing in China should take several steps to mitigate any future problems. While the filing of a trade action in a given industry is often impossible to predict, sensitivity to imports and the existence of several U.S.-based competitors can provide some indication of at least the potential that a move offshore may invite competitive scrutiny, and China CVD provides a convenient and effective means for the competition to throw a monkey wrench into the best-laid production plans. Thus, transactions must be well-documented and should, at least in appearance, be conducted as if the transaction is taking place in the U.S. The goal is not only to comply with Chinese law but to approach the transaction as if it would be investigated by U.S. commercial authorities. This requires knowledgeable U.S. and Chinese counsel.

It is a brave new world. In China, where U.S. investment is concerned, the sage adage caveat emptor has taken on new significance.

1 Investigations are ordinarily initiated in response to a petition from U.S. producers against the foreign government and exporters/[producers in that country involved in sales of the product identified in the petition.

2 A very recent interlocutory decision of the U.S. Court of International Trade calls into question the statutory authority of Commerce to apply the CVD law to China; an analysis of that issue is well beyond the space limitations of this article.

Francis. Sailer, a former Deputy Assistant Secretary of Commerce for Import Investigations, is a Partner and Andrew T. Schutz an Associate with Grunfeld, Desiderio, Lebowitz, Silverman & Klestadt, LLP; the authors acknowledge with gratitude the assistance of Canby Wood in the preparation of this article.

Please email the authors at fsailer@gdlsk.com or aschutz@gldsk.com with questions about this article.