‘The thing about China is there have always been those who think the bubble is going to burst and the die-hard optimists on the other side,’ says Holman Fenwick Willan (HFW) Shanghai head Nick Poynder. Indeed, though the second group (to which Poynder belongs) has lately been the noisiest. Not that optimists lack evidence for their confidence. With over 100 Chinese companies in the Fortune Global 500 hungry for overseas expansion, the assets of Asian banks surging since the banking crisis and an economy still growing more than twice as fast as the US, the market is impossible to ignore. Says Osborne Clarke (OC)’s Steve Yu: ‘[International firms] have to be there because their clients are there.’
What is more, despite the vast size of the country, much can still be achieved via operating in just Beijing and Shanghai, the latter being as close as China gets to a dominant commercial hub. Add to the mix the much touted Belt and Road initiative promoting outbound investment in infrastructure and the profession’s patience with investing in the world’s second-largest economy is understandable.
And yet in a dozen interviews with local lawyers it is clear that it remains tougher than ever to make returns in the PRC. As one Chinese partner puts it: ‘It’s an open secret that the majority of foreign firms operating in China don’t make profits.’
This depressing reality is down more to external barriers than tactical mistakes on the part of foreign firms but that is the hand they have been dealt. While president Xi Jinping likes to roll out free-market rhetoric in the era in which protectionism has crept back into the West’s mainstream, on the ground regulatory discrimination of foreign law firms in China is still brutal.
Most obviously they remain barred from practising Chinese law, issuing legal opinions or litigating in the national courts and thus can hardly touch a mandate without leaving large chunks of work to fast-growing national players.
But while such barriers were already factored into the equation, widespread expectations a decade ago that major Chinese companies would get used to Western fee levels have been utterly confounded. Such pressure is less severe on the outbound work that remains the main attraction for foreign firms but even there margins have continually lagged expectations.
Tariffs on Chinese imports imposed by the White House amid looming trade wars have further dampened the mood, with the value of China’s M&A into the US down 54% in the first half of 2018 according to Mergermarket.
Weighing on profitability is also a tough taxation regime: while Chinese firms are classed as partnerships and subject to a single tax layer, Western outfits’ local operations are treated as representative offices and face a 25% tax on profits and an individual income tax of up to 45% for each of their partners spending more than half a year in China.
‘It’s an open secret that the majority of foreign firms operating in China don’t make profits.’
Verein firms partly get around all this by admitting PRC law firms into their network, as with the 2017 launch of OC’s member firm Zhang Yu & Partners and Fieldfisher’s 2016 deal with JS Partners, which saw the Beijing boutique rebrand as Fei Shi (Fieldfisher China).
But profit pools remain separate and any form of control on Chinese firms by foreign players is prohibited. The Dentons-Dacheng tie-up received the blessing of the government in 2015 but is regarded as a more federal structure, and the Chinese offices still operate very much as a national firm.
Even looser are McDermott Will & Emery’s ‘strategic alliance’ with MWE China and Bird & Bird’s ‘non-exclusive cooperation agreement’ with AllBright Law Offices: both Chinese firms remain completely separate entities, although their Western counterparts are quick to talk up their links with two strong local players.
And even beyond formidable barriers, the cultural gulf between Western and Chinese lawyers has scuppered efforts to put PRC law within the framework of the global profession.
Free Trade… of a kind
China’s legal bulls have often turned to the Free Trade Zone (FTZ) in Shanghai’s Pudong district as a means to allow foreign firms to mitigate the aforementioned challenges.
Aimed at attracting foreign investment, non-Chinese law firms are allowed to set up a joint operation office (JOO) with a local player, through which lawyers can conduct marketing, share resources and offer Chinese law advice.
‘Clients appreciate the fact that we can now offer pretty much a complete service in China,’ says Hogan Lovells’ Shanghai partner Andrew McGinty, whose 27-lawyer Shanghai branch launched a JOO with 170-lawyer Fujian Fidelity Law Firm in October 2016.
Meanwhile, Poynder points to the fact that HFW’s 13-lawyer Shanghai arm’s alliance with 150-lawyer Wintell & Co in April 2016 brought together a firm with an international reach and one with ‘particularly good local connections’.
Still, with only five JOOs signed when the FTZ celebrated its fifth anniversary in September, the zone has not been the panacea foreign firms hoped for.
Only accessible to firms that have been in China for at least three years, it allows them to move a group of lawyers to shared premises in the not-exactly-central Pudong district. It is not a merger, nor indeed a legal entity, but simply a contractual arrangement between two firms that remain otherwise separate.
They can in theory share office costs and revenues, but local banks struggle with the idea of setting up a joint account without a legal entity.
Not to mention that an association with a foreign law firm does not appeal to stronger Chinese players, which see them as competitors. Those interested are usually smallish firms with little international business.
Combined with the requirement for the Chinese firm to employ at least 20 lawyers to qualify for a JOO and the persistent quality issues among China’s smaller firms, finding a partner that ticks all the boxes is a trial.
Linklaters’ 20-strong local office was on the hunt for Chinese law capability for years and held talks with several firms before resolving to spin off some of its team to launch 30-lawyer practice Zhao Sheng and then set up a JOO, which finally received the green light in May.
Ashurst’s Shanghai managing partner Michael Sheng notes that his firm, which fields 12 lawyers locally, is the only one to have entered a joint operation with a substantial Chinese player, the 600-lawyer, 15-office full-service practice Guantao. The tie-up, which was signed in January, looks a good fit for the City player, uniting it with a domestic shop with a credible reputation in projects, infrastructure and TMT.
‘There is a recent trend of people leaving international firms to join local firms because they believe that they have a brighter future.’
If Ashurst has some cause for confidence, another showing encouraging signs is Baker McKenzie, which pioneered a launch of a JOO back in 2015. A small, low-profile firm when it signed the association with Bakers in April 2015, Beijing-bred FenXun Partners has since grown to over 100 fee-earners and ‘is now able to produce a list of clients that is quite impressive for such a small firm,’ notes The Legal 500 China editor Bei Zhao.
Bakers itself is considered a ‘formidable competitor’ by Chinese firms, aided by its long history in Hong Kong, historically one of the US-based giant’s strongest offices. Bakers, however, is still often dismissed as ‘a commodity firm with commodity prices’ by the international elite.
Among those cited as considering a similar move in Shanghai is Clifford Chance (CC), which has by consensus built a formidable outbound practice and is widely regarded as one of the top international firms in the country. Sheer weight in Asia-Pacific does not hurt either, with CC’s 521-lawyer network in Asia and Australia by some way the largest of the Magic Circle.
But overall, the JOO regime five years on looks for foreign firms to have proved only a minor and inconclusive skirmish in a wider conflict they are losing to national players: the war to secure top Chinese legal talent.
Until a few years ago international firms could at least claim to be a strong choice for talented young local lawyers with Western connections. They paid better and ensured access to more premium work.
But Chinese associates trained in international firms now realise homeland-bred shops offer far better partnership prospects. And they are growing revenues at a clip.
Still recovering from the collapse of legacy SJ Berwin in Europe, $918.5m giant King & Wood Mallesons (KWM) is still prominent among the local elite. Its 1,200-strong China business has posted double-digit revenue growth for the last five years to almost $500m in 2017.
Well-regarded, 1,680-lawyer Zhong Lun is also approaching the half billion dollar mark, while 730-fee-earner JunHe rode on the local IPO spree to turn over around $220m last year. Smaller, 485-strong Fangda Partners has built a profitable cross-border practice despite fielding no offices outside mainland China and Hong Kong. Such players are still achieving consistent 15%-plus annual revenue growth that Western peers can now only dream of.
‘There is a recent trend of people leaving international firms to join local firms because they believe that they [have a] brighter future,’ says a local partner of an international firm. Notable recruits this year have included Linklaters’ former China head Fang Jian’s move to Fangda.
‘The trend is talent going from international firms to Chinese firms,’ argues KWM’s Rupert Li.
Meanwhile, international firms are unsurprisingly keeping lean local teams – even CC counts only 89 lawyers between Beijing and Shanghai. Traditionally less tolerant of diluting profits, US rivals are even more cautious. Latham & Watkins only fields around 20 lawyers, while once well-regarded O’Melveny & Myers has become the poster child for retrenchment after bleeding partners for years, its once sizeable Beijing branch reduced to a handful of lawyers. There have also been local closures by Troutman Sanders, Cadwalader, Wickersham & Taft, Winston & Strawn and Fried, Frank, Harris, Shriver & Jacobson.
And were it not China, such tough conditions would have resulted in a much larger list of firms pulling out. The optimists’ hopes still rely on the government ultimately opening up the legal sector. Yet despite promising signs of further liberalisation in financial services this summer, there is little sign that the much more sensitive legal profession is to follow. If this is a bubble, it is providing precious little growth to foreign lawyers.