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Reopening the Direct Selling Industry in China

Issue: February 2005

Keywords (click to search): FDI direct selling industry sales rep commerce pyramid schemes background on direct selling liberalization on direct selling restriction on direct selling ban on direct selling

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By David Livdahl and Zhongda Wu

davidlivdahl@paulhastings.com; zhongdawu@paulhastings.com

www.paulhastings.com

While the world's (excluding China) direct selling market generates an annual turnover of over US$89 billion with nearly 50 million sales personnel, many foreign companies are keen to engage in direct selling in China, the potentially largest market to be developed. "Direct selling" usually refers to direct selling through sales representatives. The English term has two possible translations in Chinese: chuanxiao (??) and zhixiao (??). There are no unified definitions for both terms in PRC legislation, and in business practice the same problems exist. Following China's all-out ban on direct selling in 1998, chuanxiao was viewed increasingly negatively in the Chinese media and was often directly associated with the notorious pyramid selling schemes.1 Zhixiao, on the contrary, is now more often used to mean legitimate direct selling (both multi-level and single-level2), excluding pyramid schemes.

History of China's Legal Regime on Direct Selling

Direct selling has undergone two significant stages in China. Prior to 1998, both multi-level and single-level direct selling were allowed in China. However, having seen the problems involving multi-level direct selling and an increasing frequency in pyramid schemes, the Chinese government started restricting multi-level direct selling, and launched crackdowns on pyramid schemes. The government finally stopped approving new multi-level direct selling enterprises in 1995. After investigations of existing direct selling enterprises, only 57 enterprises were approved to engage in multi-level direct selling (including Amway) and five enterprises to engage in single-level direct selling (including Avon) by October 1996.

In 1998, China issued a notice to immediately ban all types of direct selling on the concern that direct selling disturbed the social order by creating closed and tightly knit gangster-type organizations that would sell illegitimate or low-quality products at exorbitant prices.

Shortly thereafter, the Chinese government issued another notice requiring foreign-invested direct selling enterprises to operate only through fixed stores. This method of direct selling (since 1998) has imposed very restrictive qualification and operational requirements. So far, only ten foreign-invested enterprises (FIEs) have been approved to engage in this direct selling mode, including Amway and Avon.

Upcoming Changes in China's Direct Selling Market

China promised to remove the current restrictions on direct selling within three years of its WTO accession (i.e., by December 11 2004). This was supposed to be realized through domestic legislation by the end of 2004.

In a closed-door seminar held by the relevant Chinese authorities in September 2004, 22 enterprises were invited to discuss three legislative drafts on direct selling: the Administration of Direct Selling (zhixiao) Procedures, the Administration of Training of Sales Representatives Procedures, and the Anti-pyramid Scheme Fraud Regulations.

Based on various leaks, it appears that while pyramid schemes will continue to be prohibited, both single-level and multi-level direct selling (zhixiao) may be allowed. However, the total economic compensation (including commissions and bonus) of each sales representative may be capped at 25% (or 30% with approval) of one's personal sales revenue, which could severely limit the development of multi-level direct selling.

Regarding the qualification requirements, it is reported that: (i) FIEs will be required to have at least US$10 million registered capital in China, more than three years of overseas direct selling experience, manufacturing facilities and retail stores in China, sell only their own products, and be a member of the World Federation of Direct Selling Associations (WFDSA); while (ii) domestically funded enterprises will need at least an average of Rmb500 million (around US$60 million) annual turnover for the past three years to qualify. Additionally, a deposit of Rmb20-30 million (US$2.4-3.6 million) will be required to cover any future consumer complaints.

The deadline of December 11 2004 has elapsed, but the new rules have not been promulgated yet. It is reported that the Chinese government has made further revisions to the draft rules and it will take some time for the ministries involved to agree on the final draft. These revisions may include: (i) deletion of the Rmb500 million annual turnover requirement; (ii) deletion of the WFDSA membership requirement; (iii) expansion of the scope of products allowed for direct selling; and (iv) limitation on the maximum compensation for sales representatives to 25% without exception. However, other qualification requirements appear to remain unchanged.

Since Chinese officials have repeatedly expressed their concerns over the potential social problems that direct selling brings, the new rules are expected to be cautious and restrictive rather than progressive.

Endnotes

1 Pyramid scheme usually refer to marketing plans having the following characteristics: (1) a high entry fee is charged to new participants; (2) a clear distinction in rights between the upper and lower levels in the pyramid; and (3) an income structure whereby senior participants obtain fees not only from new participants developed by themselves but also later lower-level participants brought in by others. In China, such schemes are viewed as fraudulent marketing plans that are not based on selling products but are focused on entry fees paid by each participant.

2 Based on the levels of compensation to sales representatives. Multi-level sales representatives get compensation not only for their sales revenues but also the sales revenues achieved by other sales representatives developed by them, while single-level sales representatives only get compensation for their own sales revenues.


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