Risky Business: Why US Firms Are Pulling Up Stakes in China

As relations between the United States and China have spiraled dangerously downward in recent years, talk of decoupling the world’s two largest economies has grown louder. Former U.S. Treasury Secretary Hank Paulson warned in a November speech that global economic coordination is the only way to avoid future catastrophic financial crises, arguing that, if Washington and Beijing can’t get on the same page, the world is “heading for a very dangerous place.”

This uncertainty leaves U.S.-based law firms that have built up a presence in China wondering what the future has in store for them. Even before the emergence of the COVID-19 pandemic, firms including Davis Wright Tremaine, Bryan Cave Leighton Paisner and Troutman Sanders shuttered offices in mainland China in recent years. In 2020, McDermott Will & Emery ended ties with its Chinese affiliate, while Locke Lord and Vinson & Elkins pulled out of Hong Kong, marking an end to both firms’ physical presence in greater China. And in December, Baker Botts withdrew from Hong Kong, closing the curtains on 16 years in Asia after pulling out of Beijing a year earlier.

Expect even more exits. The truth is that, for many firms, a presence in China was a losing proposition even when ties between the countries were less fraught. “The Chinese have shown themselves to be pretty astute buyers of legal services. Most firms don’t make a lot of money off of Chinese clients,” says Jomati Consultants principal and former Clifford Chance managing partner Tony Williams, who believes more firms will use the ongoing tension as an excuse to pull up stakes while saving face.

Those firms that are committed to staying put have concluded that a new cold war is unlikely. And that sentiment is shared on the Chinese side. “They are unwilling partners, but they need each other in many ways,” says Zili Shao, the non-executive chairman of Fangda Partners, which Law.com ranks as the 10th-largest firm in China.

The hope is that both sides have too much to lose by unwinding a trade relationship valued at over $615 billion in 2020. That’s a key obstacle when drawing comparisons to how the U.S. and Russia got along from the 1950s until the 1980s.

“Notwithstanding some bumps in the road from time to time, those economic imperatives are likely to continue to drive a lot of activity between the two countries and all the aspects of the business communities in both countries,” says Hong Kong-based Paul Hastings partner Neil Torpey. “But the scope and depth of the economic relationships between the countries is so deep that it would not be so realistic to think there would be a total decoupling.”

That doesn’t mean there won’t be change, with particular industries—telecommunications or solar, for example—finding their way onto the radar screen at particular points of time.

“U.S.-China deals have become more complicated. But when I say more complicated, that doesn’t mean they’re not happening; it just takes more legal work and more legal structuring,” says Goodwin Procter Hong Kong partner Yash Rana. “Frankly, that’s better for the likes of us, because it shows the value we bring to the table.”

Nonetheless, for American companies already established in China and Chinese companies doing outbound business, uncertainty is rising. And it would be wrong to understate the political tensions. The U.S. has always used legal tools to respond to its issues with China, according to Crowell & Moring Asia practice leader Evan Chuck, who points to actions targeting unfair trade practices, illegal subsidies and dumping.

“In the last six years, it’s moved from a rules-based discussion to a much more politically sensitive discussion in the U.S., China and Europe,” Chuck says, highlighting sanctions and export controls on the U.S. side and China’s response last June with its anti-foreign sanctions law, which allows Chinese citizens and organizations to sue for damages if harmed by sanctions. That’s a break from what he’s seen over nearly three decades of law practice.

“The risk flows out not just for companies but for law firms,” Chuck adds. “The challenge for traditional foreign firms is to understand where their added value is, both for multinational corporations and for Chinese companies who are doing outbound work, and refine [it] with precision.”

IPOs in Flux

When Alibaba went public on the New York Stock Exchange in 2014, the move seemed like a win for both the Chinese e-commerce giant and the American investors poised to profit from its success and the promise of more to come. As of May 2021, nearly 250 Chinese companies were trading on American exchanges, with a market capitalization of $2.1 trillion. But with the U.S. Securities and Exchange Commission imposing new disclosure requirements for Chinese firms looking to list in New York, plus China increasing its own oversight of these listings, they’re slowing to a trickle.

Instead, these companies are looking at Hong Kong and, to a lesser degree Singapore, to raise capital.

That could be trouble for U.S. firms like Skadden, Arps, Slate, Meagher & Flom, which advised ride-sharing app Didi Chuxing on a July 2021 IPO on the NYSE before the Cyberspace Administration of China launched a cyber review into the company, and Davis, Polk & Wardwell, which was advising Chinese medical data company LinkDoc before it dropped its plans to list in the U.S. after the CAC announcement. Both firms declined to discuss the future of their China-facing business. And in late November, the Chinese government reportedly asked Didi to delist, further evidence of the headwinds in this area.

“When a company seeks to raise capital and one or more countries’ exchanges become more difficult to access, they simply move to other countries’ exchanges. And fortunately for us, we’re present in most of the places where companies look for capital,” says Morgan, Lewis & Bockius managing partner Steve Wall.

Yet with the volume of listings in Hong Kong rising, American firms find themselves in competition both with London firms with large teams and long track records in the city, as well as Chinese firms, which have been growing their capabilities in the space. That doesn’t mean they’re going to be shut out. Skadden, for example, has continued to advise on a number of secondary listings in the city even with other U.S. advisers being dropped.

Torpey concedes that more firms are fighting to get that Hong Kong IPO work. But he argues that Paul Hastings is in a strong position to land a healthy share of it.

“We have a 20-year track record of doing IPOs in the Hong Kong market,” he says, noting relationships with Western underwriters like Morgan Stanley and Chinese underwriters like the China International Capital Corp. “We feel ready to compete and succeed in getting at least our fair share of that work.”

Cross-Border Investment

Just like U.S. exchanges attracted growing Chinese companies, the prior decade saw Chinese investors gobbling up assets in the U.S. and elsewhere overseas. There’s no better example than Anbang Insurance, which bought the Waldorf Astoria Hotel in 2014 for $2 billion and followed that purchase with a portfolio of 16 other hotels worth $6.5 billion in 2016.

But the geopolitical tensions between the two countries have served to dramatically decrease this activity. The Committee on Foreign Investment in the U.S., or CFIUS, is eyeing a wide range of potential transactions, even beyond sensitive industries like semiconductors or green technology.

“We’ve seen large transactions that we thought would not be subject to CFIUS jurisdiction, and CFIUS will still assert the jurisdiction and reject it. The whole process is so difficult, even in industries that are not so sensitive,” says Paul, Weiss, Rifkind, Wharton & Garrison corporate partner Greg Liu. Many China-based private equity companies that have made these purchases in the past are now staying away, unwilling to put in six months of work or more trying to secure a clearance that might not come through in the end.

There’s also growing pressure on inbound investments in China. The Chinese government recently passed multiple laws regulating the cross-border transfer of certain data and personal information, increasing the impediments for foreign businesses looking to operate in the country. Regulators in both the U.S. and China, meanwhile, are looking with increased scrutiny at variable interest entities, or VIEs, a business structure that’s been used to circumvent Chinese restrictions on foreign ownership of local businesses. Taken together, these two developments will likely have a chilling effect.

Some companies are looking to unwind previous moves. “Instead of representing U.S. companies in additional joint ventures in China, we now tend to be representing companies that are seeking to exit or are having more trouble operating in China,” Wall says.

That doesn’t mean inbound transactional work is kaput. “There will always be deals, whether it’s new deals or working out existing deals or exits,” Chuck says. But he’s convinced that this moment has altered the preconditions for law firms to be successful in advising clients on deals involving China. More than ever, it’s necessary to be able to connect pure M&A capabilities to deep insights in what’s going on in government agencies on both sides of the Pacific.

Regulatory Know-How

Amy Chen is a veteran in-house lawyer who served as Alibaba’s first in-house counsel during its startup phase and now serves as executive director and associate general counsel at U.S.-based, China-owned IT distributor Ingram Micro. She acknowledges the decline in Chinese foreign-direct investment in the U.S. and the shift away from U.S. capital markets to those in Hong Kong, but she doesn’t see a significant shift in strategy for the U.S. businesses that already have built a presence in China.

A recent survey from the U.S.-China Business Council backs this up. Ninety-five percent of member companies said their China operations are profitable. Only 6% said their resource commitment to the country would be curtailed, while the balance would either keep resources steady or increase them. That’s an opportunity for firms that have the necessary capabilities.

“For in-house counsel, in an environment where U.S. companies are not exiting China en masse, it’s a very complex environment. We’re already very busy. Now you have to layer on U.S.-China geopolitical tensions and a wave of regulations coming at you from the Chinese and U.S. governments,” Chen says. “Some of that is tit for tat and hard to navigate.”

In addition to regulations on data transfer and on VIEs, there’s also the impact of continued U.S. tariffs on certain categories of imports. And the U.S. has imposed sanctions on certain Chinese companies and officials over the country’s crackdowns on political activity in Hong Kong and purported human rights violations in the western province of Xinjiang. That prompted the recent anti-sanctions law. All of these added complexities have changed the game for U.S. law firms.

“There are firms with good mergers and acquisitions ability in China, but in our experience they have very little understanding of how sanctions impacts their ability to do work,” Chuck says. “In my practice, what’s most impactful is a knowledge of the sanctions regime for all countries involved: the U.S., the E.U. and China. That’s where the action is, back and forth.”

Emerging Areas

If full-scale decoupling remains unlikely, U.S. firms can look to several other areas for new fields of opportunity. With so many Chinese companies having already established themselves as global businesses prior to this current moment of uncertainty, they’ve found themselves under the jurisdiction of countries all over the world, each with their own compliance regimes.

Paul Hastings has seen this as an opening for its investigations, white-collar and compliance practices in the U.S. and elsewhere in the world. “That’s something we’ve been building deliberately in our offices in Asia,” Torpey says. “The amount of work has been enormous in the last five or six years.”

International arbitration practices are thriving too, says Wall, with geopolitical tensions prompting Chinese companies to shy away from applying U.S. or English law as a basis for cross-border commercial agreements. Instead, with Singapore law becoming more common, arbitration work in that forum is thriving.

And Chen believes that firms which establish sound intellectual property capabilities in China will be rewarded for their efforts. “The U.S. has pressed on this, and the Chinese government has continued to build out their IP laws and courts, and there’s more judges with expertise,” she says. She’s also optimistic that the U.S. and Chinese governments will find ways to work together to respond to climate change, prompting demand for green finance and green technology capabilities.

Local Competition

These emerging areas also present an opportunity for indigenous Chinese firms, which have been rapidly growing in sophistication in recent years.

Veteran legal industry consultant Peter Zeughauser says they’re already dominating the market for multinational corporations’ inbound cross-border work. “They’re going to be as dominant in their home market as the Magic Circle firms are in their home market and the Am Law 200 are in our own home market,” he says. And when they inevitably grow their share of outbound work from China-based multinationals and state-owned enterprises, they will join the Magic Circle and the Am Law 200 as the “the third leg of the stool,” he says.

As a buyer of legal services, Chen agrees. “Two or three of the best ones are ready to be competitive in certain areas,” she says. “In terms of understanding the Chinese regulatory landscape, they’re very useful. They often have contacts in different ministries and can make inquiries on a no-names basis.”

These firms may also be benefiting from a little help from the Chinese government. One Hong Kong partner in a U.S. firm, who requested anonymity to discuss a sensitive subject, believes that over time political leaders will signal their contacts in state-owned enterprises to choose Chinese attorneys, at the very least, and ideally Chinese firms. “That will create real competitive issues in the marketplace,” he says.

Zeughauser adds that Chinese leaders haven’t complied with their obligations proscribed by the World Trade Organization to open the market to foreign firms. “They’ve created an unlevel playing field that favors the Chinese firms, and we can expect to see that continue into the future for an indefinite period of time,” Zeughauser says.

But he also believes the government has incentives to begin liberalizing the Chinese market, and he reports informal conversations among senior lawyers in Chinese firms indicating the prospect of more collaboration between the two legal systems.

“The Chinese government is very strategic,” Zeughauser says. “Just like they’ve done with American technology companies, they want to see Chinese firms adopt best practices, particularly for professional development and management of their firms. We’re going to see some easing of the restrictions on practice in China in order to make it more friendly to foreign firms, and therefore make best practices available and more visible to the Chinese firms.”

Values Under Fire

U.S. firms that plan to stay in China for the long haul can also prepare to have their values tested, just as Mayer Brown did in October. The firm first undertook efforts to have a pro-democracy statue removed on behalf of Hong Kong University. Then, when it withdrew its representation of a longtime client on the matter, Hong Kong’s former chief executive called for a boycott of the firm.

“Big Law’s pro bono commitment to human rights around the world is going to be a hotspot in the relationship between the Chinese bar and the U.S. bar,” Zeughauser says. “This is going to flare up more often than not. There are too many Chinese lawyers in prison for doing pro bono human rights work, and how the U.S. firms respond to that is going to be dicey.”

In a way, globally inclined American firms find themselves in a similar position to the National Basketball Association, which has encouraged players to speak out against injustice around the world, while at the same time pursuing the financial opportunities that come from having a presence inside the lucrative Chinese market.

But if full-scale decoupling is more of a frightening worst-case scenario than a likely outcome, this tension is going to be unavoidable for any profit-pursuing entity that also happens to contain individuals with strong moral commitments. It’s yet another hurdle that firms will have to navigate as they seek to find balance—and success—in China. The risks are high, but so are the rewards.

Jessica Seah contributed to this article.

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