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International Law,
Corporate

Feb. 7, 2022

A case for corporate board introspection on China

While the U.S. government has made some recognition of its of policy regarding China, it’s important to ask whether corporate boards are undergoing the same sort of introspection.

Joe Moschella

General Counsel Jukin Media, Inc.

Email: joe@jukinmedia.com

Joe is general counsel at Jukin Media, Inc. and assistant general counsel at Trusted Media Brands, Inc. His views are personal and not those of his employers.

The team from China enters the stadium during the opening ceremony of the 2022 Beijing Olympics in Beijing on Friday. ( New York Times News Service)

It's always difficult to admit policy failures, but by their actions across the Trump and Biden administrations, U.S. policymakers implicitly have admitted the failure to achieve a number of the historical justifications for economic engagement with China. Through the recently enacted Uyghur Forced Labor Prevention Act, the ongoing additions to trade blacklists of China-based companies for their complicity in human rights abuses, and the Department of State's designation of an ongoing genocide in Xinjiang -- among numerous other policy changes -- it's fair to say that the era in which such engagement was seen as no worse than a net-neutral bargain has come to an end.

In President Bill Clinton's speech in March of 2000 in favor of permanent normal trade relations with China, he noted that critics of the move say that, "China is a growing threat to Taiwan and its neighbors; we shouldn't strengthen it. Or, China violates labor rights and human rights; we shouldn't reward it." The concerns were as familiar then as they are today; however, Beijing knew that if these concerns really mattered, then a two-track process of engagement would never have been created. Even as to economic engagement, Beijing has repeatedly failed to reciprocate on market entry and create a level playing field for foreign firms, and global frameworks have provided no timely or effective recourse for the aggrieved. ("Beijing" is used herein as shorthand for the political and party leadership of the PRC, differentiating it from its people who are also often its victims).

But while the U.S. government has made some recognition of this failure of policy, it's important to ask whether corporate boards are undergoing the same sort of introspection, and whether the decisions being made today are with consideration of the shifting mood of policymakers on matters of engagement and the increasingly hostile and nationalistic attitudes of Beijing. Americans are also becoming well-educated on these concerns, and executives who feign ignorance or attempt neutrality no longer mollify Beijing or placate the public. Those directors who aren't currently reviewing their corporate plans may also find themselves on the wrong side of policymakers, the public, and potentially, the law.

Directors are generally subject to the duties of care and loyalty, the latter of which includes a duty of oversight, i.e., setting up systems and controls to monitor and identify risks to the corporation, and implementing measures that remediate those risks and enhance compliance. In any changing legal and operational environment, meeting one's duties is no longer a passive activity, and simply doing things the way they've successfully been done in the past is unlikely to be a satisfactory defense.

In the event a board is later challenged in its decision-making, courts look to the business judgment rule to determine whether the board has acted in accordance with its fiduciary duties. The "rule" itself is better explained as a presumption -- i.e., if decisions are made in good faith, with the care of a reasonably prudent person, and with the reasonable belief that the directors are acting in the best interests of the corporation, board members are provided with the presumption that their actions will be upheld. Note that maximizing returns to the detriment of all other considerations is not a requirement to meet this presumption; however, reasonable prudence is.

Over the past several years, satisfying the necessary prudence in China has been difficult and shows no signs of becoming any easier. The country has been effectively closed to foreigners for two years, and the most optimistic projections are that the nation won't begin an opening until 2023 after completion of its 20th Party Congress. In its recent fits of nationalism, Beijing also continues to disparage mRNA-based vaccines in favor of less-effective domestic formulations, which when coupled with its zero-COVID policies, make a timely re-opening even less likely. Beijing's reopening plans may not even be directly tied to end of the pandemic, as some believe the leadership is quite satisfied with the effects of its closed border and the continuing justification for further social controls. But even with the possibility of entry, the U.S.'s travel advisory on China warns that it "carries out arbitrary and wrongful detentions and uses exit bans on U.S. citizens and citizens of other countries without due process of law," which makes it a corporate risk to send anyone on work-related travel.

These difficulties, especially when coupled with mechanisms like those found in the Uyghur Forced Labor Prevention Act, which create a rebuttable presumption that all goods manufactured in Xinjiang, even in part, are the product of forced labor, make many China-based operations increasingly difficult to defend. Reports in January by the South China Morning Post have indicated a burgeoning industry in China-based consultants who can help companies game routine audits, and in 2021, the Department of State warned that supply-chain auditors in China have been harassed, detained, threatened and subjected to surveillance by local authorities. Diligencing investments has become more difficult, and diligencing suppliers has become nearly impossible. Meanwhile, outside of China, navigating regulatory waters in the U.S. is not getting any easier.

In the U.S., the two tracks of engagement that separate the economic from other interests, such as human rights and national security, are beginning to merge. The Committee on Foreign Investment in the U.S. has taken a more active role in evaluating (and denying approvals of) inbound investments from China and continues to build its enforcement arm to hunt for deals that should have sought approval. Outbound investment has generally been ignored by U.S. policymakers, but in 2022, bipartisan support is coalescing around the National Critical Capabilities Defense Act, which is intended to prevent the offshoring of certain supply chains and to stop the transfer of critical intellectual property to foreign entities. According to the Rhodium Group, 43% of U.S. foreign direct investment to China over the past two decades would have been covered under the act's scope. And in 2024, the Holding Foreign Companies Accountable Act will begin to bite, as delisting can begin for Chinese companies on U.S. exchanges whose China-based audits can't be reviewed by U.S. regulators.

U.S. conversations about sourcing from other nations and creating investment indices ex-China have now become commonplace, and the arbitrary regulatory crackdowns in China in 2021 that decimated some of its domestic industries, such as tutoring, have put multinationals on edge. Recognizing this, in late January of this year, the China Securities and Regulatory Commission met virtually with heads of Western banks to reassure them over the direction of China's growth and regulatory prospects claiming that recent actions are transitory, but such heads should take note that continued engagement will come with an expectation of a public commitment to Beijing's interests. On the eve of the Winter Olympics, the matter of women's tennis player Peng Shuai's disappearance and the International Olympic Committee's willingness to provide cover to Beijing shows that the price of a seat at the table is one's personal and organizational reputation.

Even for partners willing to toe the regulatory line, success is decidedly not guaranteed. Hollywood continues to treat subjects like Tibet, Taiwan and Tiananmen as taboo, but 2021 saw a year in which only 21 Hollywood films were released in China on a revenue-sharing basis, well under the current quota. Meanwhile, in November 2021, "The Battle of Lake Changjin" became the highest-grossing film of all time in China and depicts the Chinese army's fight against U.S. forces in the Korean War. Foreign companies may not have the appetite to make the films that China's film bureau (now under direct control of the Propaganda Department of the Communist Party) increasingly wants to see made. More recently, reports indicate that starting this April, the credits for Chinese television dramas will begin to identify actors who have foreign citizenship, a move to expose potential "dual loyalties," suggesting a further devolution into nationalist aims. Perhaps the inflection point has been reached at which making films for the rest of the world could outperform tailoring films just to placate Beijing, and perhaps if one is investing in theme parks or merchandising in China, there should be a discussion about future growth plans if they're based on content that the people of China will never see.

Similar inflection points may now exist in numerous industries, and boards should be undertaking these examinations quickly in order to fulfill their corporate duties and avail themselves of the protections of existing corporate law. Staying the course without updating one's diligence is no longer a defensible position, and as Lampedusa famously wrote, "for things to remain the same, everything must change." 

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