Succeeding in China: The Risk of Doing Business in China

1. Succeeding in China: The Risk of Doing Businessin China Presenters:Andrew Walker, Director, Deloitte Consulting Jim Chapman, Partner, Foley & Lardner LLP Silicon Valley RIMS January 31, 2013

2. The Focus of this presentation is on identifying and mitigating the risks of doing business in China • China represents a large and attractive market for Multi-National Companies (MNCs) • There have been a series of well-publicized incidents involving U.S. companies operating in China • MNC’s have found ways to be successful in China – to both grow their businesses & mitigate risks • A programmatic approach to risk reduction has proven to be the most successful approach

3. Macroeconomic Issues in China

4. China offers significant market attractiveness for MNCs China’s demographic and economic profile make it the world’s fastest growing economy. China’s Global Positioning1 Global GDP Share3 GDP Growth (9.3%) among emerging and developed nations # 1 2010 2017 (proj.) # 1 United Nations FDI Attraction Index Rank 2 +12.2% CAGR # 1 Country Population (1.35 Billion) # 1 Total Exports ($1.90 Trillion) # 2 Total GDP ($7.3 Trillion) # 2 Total Imports ($1.66 Trillion) China provides MNCs with a strong economic and demographic foundation for growth and projects to continue dwarfing other major emerging markets Sources: (1) WorldBank(2) UNCTAD (3) IMF projections, Deloitte Analysis

5. China offers significant market potential that can be hampered by significant risks However, unique risks may limit MNCs ability to capture the growth potential . . . Companies are expecting increased revenues from China over the next 3 years Revenue Expectations from China in next 3 years Potential revenue opportunity in China Billions Risk-adjusted revenue • As documented in mainstream newspapers, magazines, journals, and trade publications… Global weakness has affected China’s economic growth, slowing to 7.6% in Q2 2012, however the China market is growing faster than the global average indicating continued investment opportunity Sources: (1) Deloitte Consulting emerging markets survey conducted in 2011; (2) Weekly Economic Update (7/9/12) (3) 22 companies reporting revenue earned in China, Economist Intelligence Unite and Deloitte Analysis

6. Changing regulatory landscape is making China more attractive for MNC In addition to China’s economic and demographic profile, new leadership and policy changes are making China a top destination for investment. Number of Recently Initiated Trade Restrictive Measures Top Destinations for MNC Investment Despite increased global protectionism, China has imposed fewer restrictive trade measures1 compared to other major economies. During the same period 21 new trade liberalizing measures were initiated. Over 60% of executives surveyed by the UN Conference on Trade and Development cited China as a top 10 destination for investment between 2012 and 20142. Sources: (1) Data from 9/2008 – 7/2011; Mohini, D., Hoekman, B., and Malouche, M., “Taking Stock of Trade Protectionism Since 2008” (2) UNCTAD

7. Overview MNCs already operating in China are expecting substantial near-term revenue growth 55% of surveyed companies are expecting increased revenues from China between 2011 and 2014. Revenue Expectations from China1 Potential Revenue Opportunity in China ($B)2 An index of 135 companies weighted by their revenue share from China has climbed 129% since 2009 compared with the S&P 500’s gain of 57%.3 Sources: (1) Deloitte Consulting emerging markets survey conducted in 2011; (2) 22 companies reporting revenue earned in China, Economist Intelligence Unit and Deloitte Analysis; (3) The Economist

8. Legal, Regulatory and Transaction Issues

9. Technology Transfer Legal Framework • China’s Regulations on Administration of Technology Import and Export (Technology Regulations), effective January 1, 2002, govern the import and export of technologies into and out of China. • The Technology Regulations classify technologies into three broad categories, including: • Prohibited technologies: Cannot be imported into or exported out of China. • Restricted technologies: Import and export must be pre-approved by the relevant Chinese governmental authority, and copies of the relevant technology transfer agreement must be submitted to the relevant governmental authority. • Permitted technologies: Can be imported into or exported out of China without prior Chinese governmental approval.

10. Forms of Technology Transfers Technology transactions may take a variety of forms. All of the following transactions are subject to the Technology Regulations: • Patent assignments • Assignments of patent application rights • Patent licensing • Assignments of know-how or trade secrets • Licensing of know-how or trade secrets • Technical services and other unspecified forms of technology transfer covered by the Technology Regulations • Cooperative research and development contracts • Technology consultancy contracts • Technical training contracts • Technology brokerage contracts • Software import and export contracts • Trademark licenses or assignments involving patented or non-patented technology

11. Applicable Contract Law Unified Contract Law, adopted in 1999 provides substantial freedom for the parties to enter into agreements.

12. Obstacles to Technology Transfer to China • Lack of control over future developments, modifications and enhancements of transferred technologies. • Warranty requirements. • Collecting royalties and other payments. • Protection of Intellectual Property. • Lack of Trust.

13. Mandatory Provisions of Chinese Law • Chinese law requires that the foreign licensor to: • “Guarantee” that the licensed technology be complete, correct, valid, and capable of accomplishing the specified technological objectives. • “Guarantee” that it is the legal owner of, or the party with the right to license, the technology. • If the Chinese licensee infringes on another party’s right by using the licensed technology pursuant to the license agreement, the licensor is required to bear the responsibility for such infringement.

14. Prohibitions • The Technology Regulations prohibit the following provisions: • Requiring the transferee to accept incidental conditions unnecessary for the imported technology, including the purchase of unnecessary items. • Requiring the transferee to pay for, or undertake obligations relating to, a technology for which the patent right has expired or has been announced as invalid. • Restricting the transferee’s improvement of the technology provided by the transferor, or restricting the transferee’s use of the improved technology. • Restricting the transferee’s acquisition from a third party of any technology similar to, or competitive with, the technology provided by the transferor. • Unreasonably restricting the transferee’s channels or sources for the purchase of raw material, parts, components, products, or equipment. • Unreasonably restricting the quantity, variety, or price of products produced by the transferee. • Unreasonably restricting the transferee’s export channels for products manufactured by the transferee using the transferred technology.

15. Key Issues of a Technology Transfer Agreement Typically, a technology license agreement will cover the following key issues points: • Field of use • Geographic scope/territory • License fees and payment terms • Ownership of technology • Ownership of improvements • Exclusive or non-exclusive/sublicense • Nondisclosure • Noncompetition • Term/termination • Indemnities/liabilities • Dispute resolution • Governing law • Governing language (i.e., Chinese or English)

16. Key To Successful Technology Transfer • Find the “right” licensee. • Invest in the relationship and work to build trust. • Thoroughly document the transaction. • Work to keep interests aligned. • Maintain constant communication and support.

17. Risks and Mitigation Strategies

18. Mitigating risks to profitability and value creation is criticalAll are related to protecting a company’s brand/reputation High USG-Related Business IP Protection 1 1 2 Ineffective Legal Entity & Business Structure 2 Potential Impact U.S. Ethics Laws Export / OFAC Compliance 5 4 3 Partner Turning Competitor 3 Supply Chain 4 6 9 5 Profitability in China Market Restrictions Likelihood 8 6 7 7 8 Medium High 9 Low

19. Protecting IP is typically cited as the most significant challenge to operating in China % of Companies Citing Challenges in China as Significant1 IP Risks in China • Local companies are known to introduce rival products within 2-6 months of a new product introduction by an MNC • Significant number of IP related lawsuits between MNCs and Chinese companies indicate existence of IP infringement practices (~60,000 in 2011, up from ~43,000 in 2010)2 • Government regulations on IP creation and usage makes it mandatory for MNCs to share IP in China in certain instances Sources: (1) Deloitte Consulting emerging markets survey conducted in 2011, (2) China Patent Agent LTD., (3) Nera Economic Consulting estimate

20. An IP protection strategy should be integrated from the product strategy through the operating model and tactics 1 2 Implementation Steps 3 4

21. In addition to IP protection concerns, there is a risk that U.S. government (USG) agencies could have concerns about offshore operations in certain countries Key Risks Mitigation Approach • Certain USG agencies may have concerns surrounding their product and/or service providers operating in certain countries • Key concerns appear to revolve around the following: • Loss of U.S. IP • Products or product code being infiltrated or corrupted by foreign parties • Network and IT access into USG data centers or systems • USG related information becoming accessible • Companies should wall-off foreign operations from public sector business in a way that is auditable • Leading practices include creating two sets of operational, network, and IT firewalls: • Between Offshore and US businesses • Between US and US Government Services divisions • Companies should proactively develop programs to educate government customers • Mitigation approach should be structured to address operations for each business function across eight key security threads • Negative USG perceptions of the company may impact existing and future contracts / business may lead to loss of revenue and USG audits

22. Protecting IP and assuaging U.S. Government concerns requires a reengineered operating model Deloitte’s FOCI-Mitigation Toolset(Foreign, Ownership, Control, or Influence) Functional Example

23. Foreign Corrupt Practices Act What are the risks? Corruption in China –pace of change, growing economic prosperity, historical practices US FCPA – Prohibits payments of something of value to foreign officials or members of a political party to obtain or retain business. Violations and Penalties – Anti-bribery: • Individual criminal fines up to $250,000 and imprisonment up to 5 years • Companies may be fined $2 million for each violation • Violations and Penalties – Violation of accounting provisions • Individual criminal fines up to $5 million and imprisonment up to 20 years • Companies may be fined $25 million for each violation What is an improper gift or payment? FCPA prohibits corrupt payments through intermediaries

24. U.S. Foreign Corrupt Practices Act Understand the Danger Signs Large sales to governmental agencies or SOE’s with high unit price and low frequency; A request for commission payments to be made to bank accounts in other countriesor to people or companies who did not perform the services; Excessive payments or commissions for services rendered or insufficient staff to perform the services to be rendered; Vague deliverables in contracts; Losing bidders hired as subcontractors; Favorable treatment of one supplier over another; Lack of relevant experience of a successful bidder; Unnecessary third parties performing services; Lack of documentation from agents; A representative or distributor has family or business ties with government officials; A representative or distributor requires that his or her identity not be disclosed; A potential government customer recommends or requires that the U.S. company use a particular representative or distributor; A representative or distributor makes requests such as backdating or altering invoices; or Arepresentative or distributor requests that an invoice be inflated.

25. FCPA Compliance Program Components of Program Process and procedures Oversight Audit

26. Embezzlement RiskWhat to watch out for? Key Risks Mitigation Approach • Fraud is rampant in China – “Opportunistic” vs. “Systemic Malfeasance” • There is a view that there are no consequences • It is OK to take advantage of a foreigner • Pre-employment screening – verify everything • Certificate of No Criminal Record –provided by local police station and can be verified • Manage the HR Manager in China – Kick-backs and payoffs are common • Do not allow the GM to hire the finance manager

27. Contractual RiskWhat to watch out for? Key Risks Mitigation Approach • Chinese view of contracts - tool for building a relationship • Negotiation and re-negotiation • Enforcement • Formation basics • Understand the role of contracts – Use strong contractual protections such as arbitration outside of China, governing law and language, waiver of sovereign immunity • Build personal relationships on a day-by-day basis • Learn the culture – role of relationships, how foreigners are viewed, the role of “face”, humility, sincerity and other concepts • Understand the role of contracts and cultural differences.

28. Human Capital RiskWhat to watch out for? Key Risks Mitigation Approach • The Chinese view of the workplace • Employees are not important • Hierarchy • *Loyalty – To whom do the key employees owe their loyalty? • Turnover and its costs • Integration • Training • Loyalty programs • Loyalty issues control and influence protection of IP and one’s brand and reputation

29. Operating Risk What to watch out for? Key Risks Mitigation Approach • Supply chain visibility – downstream and upstream – and chain of command • Control over costs and pricing • Differences in protection of property and business continuity efforts / requirements • Quality control and assurance • IP • Compartmentalize production • Control the production process • Keep key technologies in the US • Employ rapid versioning • Integrate supply chain requirements through contracts, quality assurance, and risk management best practices • Visibility is most important in understanding critical operational risks

30. Executive Office Legal & Risk HR IT Sales & Marketing Operations Finance Risks should be managed through an integrated, cross-functional program Function Responsible For Mitigating Risk 5 6 7 8 2 3 1 3 5 6 8 7 2 3 5 6 8 4 Sample Roadmap 5 1 2 3 4 5 1 5 8 6 7 5 1 3 1 2 3 4 6 8

31. Summary Key Lessons Learned Do not leave common sense at the border Understand the role of the Chinese government in day-today business and develop a governmental relations program Develop “guanxi” Select the “right partners, suppliers and resellers Always have strong legal foundation for business relationships

32. Andy is a strategy advisor with more than 15 years of experience leading efforts to help business executives overcome their most pressing challenges. His primary focus is on advising companies on ways to improve financial position by restructuring their operating models to improve the focus on future growth prospects. In addition to this focus area, Andy is a lead in Deloitte’s cross-border investment practice with a focus on helping companies meet U.S. national security expectations, as well as helping them protect their intellectual property as they expand globally. He has led Deloitte’s efforts on a number of high profile CFIUS cases. Andy has worked with telecom and high tech clients and has worked in China, Latin America and Europe on their behalf. He is the author of a number of articles, including, most recently an article published in the Wall Street Journal entitled “Improving the Yield on your corporate investment portfolio.” Director Strategy Practice Deloitte Consulting

33. Jim is a partner at Foley & Lardner, a leading international law firm. He is a corporate and securities lawyer focusing on start-up and emerging publicly traded and privately held companies looking to expand domestically and internationally and the venture capitalists, private equity groups and angels that invest in them. He has substantial experience in international transactions including mergers and acquisitions, foreign direct investment, technology transfers and joint ventures in China. Jim has been involved in approximately 250 mergers, acquisitions and finance transactions and is the author of approximately 50 articles and has given over 50 presentations in the last four years on issues related to raising venture capital, mergers and acquisitions, start-ups, doing business in China and other topics. Jim has been recognized by Law 500 as one of the best lawyers in the US for mergers and acquisitions, was named one of the Top 25 Clean Tech Lawyers in California in 2011 by the Daily Journal and one of Northern California’s Super Lawyers by San Francisco Magazine and Law and Politics Media. Partner Foley & Lardner, LLP