Boston Business Journal

Breaking the great wall to reach Chinese biotechs

by Barbara A. Jones
July 11, 2008

The Chinese biosciences industry is fast becoming the most desirable source of innovative technology and collaboration for U.S. biotech, medical device and diagnostic companies.

The turning point for the Chinese biosciences industry came in 2001 when a new government mandate for “innovation” supplanted the traditional policy of “follow-and-copy.” Strong national and provincial support, aided by low-cost labor and internationally educated scientists, has led to the development of an extensive research and development infrastructure.

Add newly adopted incentive tax rates of 15 percent for bioscience companies who conduct continuous R&D, and the economic benefits for U.S. companies are clear.

However, establishing a strategic alliance or license arrangement with a Chinese company or university is hardly straightforward. Apart from the obvious cultural and language differences, numerous legal and regulatory hurdles must be overcome. Structuring the most suitable entity or vehicle to support the proposed relationship, coupled with protecting the intellectual property rights associated with the venture, are the key issues facing U.S. bioscience companies and their investors.

Recent changes to the regulation of foreign investment in Chinese entities continue to present major navigational challenges. Of particular concern to Chinese regulators have been structures that result in “round-trip” investments, where the ownership of a Chinese company is transferred offshore to obtain the benefits of being a foreign-invested enterprise. Creative legal structures have been developed to minimize the need for governmental approval and registration and to facilitate, among other things, the distribution of income and assets offshore to the non-Chinese shareholders or partners. Collaborations or strategic alliances with a Chinese company most typically take the form of a contractual joint venture (CJV) or a wholly foreign-owned enterprise (WFOE).

In a CJV, profits and losses and liability ratios do not necessarily correspond with the proportion of each party’s capital contribution to the enterprise. A CJV enables one party to recover its investment with priority over the other parties. This structure is viewed as ideally suited for bioscience alliances where the U.S. party will typically seek to exercise management and economic control over the venture without controlling the equity.

A WFOE is a Chinese limited liability company that is owned by an offshore, foreign-owned company. The offshore company often serves as an intermediate holding company between the Chinese entity and the ultimate parent in the United States, and is formed in a tax-friendly jurisdiction. New M&A rules, effective in September 2006, imposed a requirement for approval by the Ministry of Commerce of certain foreign acquisitions or investments in Chinese companies; WFOEs established before September 2006 were exempted from this approval requirement.

However, with the issuance of further regulations in 2007, these legacy WFOEs are now required to be aged for three years before engaging in an international financing transaction. Other structures, such as the “Sina Corp. Model,” utilize various contractual arrangements to transfer the equity interests and preserve a suitable economic return, without being subject to regulatory approval.

Intellectual property protection under Chinese law — long a significant concern internationally — is improving with recent case law helping to close the regulatory gap. Nonetheless, rights holders must be proactive in protecting their intellectual property through national and local registration of patents and trademarks and recordation of license agreements. Trademark registration should include a Chinese language equivalent of the English mark; otherwise the rights to the Mandarin mark will be rapidly usurped. Registrations currently take up to 40 months and no license fees can be remitted offshore until the registration is complete.

Notably, IP and technology transfers and licenses, technical consultancy and service arrangements, as well as cooperative research and development, are subject to approval by the Ministry of Foreign Trade and Economic Cooperation, or MOFTEC. Before a collaboration agreement is signed, MOFTEC will determine if the Chinese party has the right to engage in foreign trade.

The high demand for cost-effective R&D and commercialization capability has caused irreparable cracks in the Chinese system. This is good news for the U.S. bioscience industry as continuing pressure will lead China towards a competitive and credible regulatory structure and facilitate the development of innovative and critical therapies and devices.

Barbara A. Jones is partner-in-charge of the Boston Securities Practice Group of McDermott, Will & Emery. She is currently the vice-chairwoman of the American Bar Association’s Subcommittee on International Securities Matters and will begin a three-year term as chairwoman in August.