10 July 2017

A Castle Built on Sand: Challenges and Opportunities for Network Marketing in China

This article was written by Mark Schaub(International partner), Atticus Zhao(Senior associate) and David Hong(Foreign law consultant).

China is the promised land for many international Network Marketing companies.

China has what Network Marketing companies thrive on: consumers – 1.4 billion of them; a fast-growing middle class of over 300 million – interested in upmarket goods but also open to opportunities; and finally, an exploding market appetite for Network Marketing-friendly products – dietary supplements, cosmetics and homeware are all experiencing double digit growth rates.

It is also helpful that international brands still dominate much of the market for these types of consumer products. Over 40% of Chinese customers favor international health brands and 9 out of the top 10 cosmetics companies in China are international.

However, it is very important to note that despite this opportunity network marketers do face real and serious challenges in China:

Regulatory Challenges

Pyramid selling or selling via multi-level marketing (MLM) is illegal in China.

If Network Marketing companies wish to operate within China it is crucial that they adjust their business in order to operate legally. The main restrictions are that a distributor cannot earn compensation based on sales of products to distributors lower down the hierarchy or “down-line” in the same network.

Non-compliance can have very serious repercussions: companies branded as being illegal pyramid schemes will face official investigation which will often result in the arrest of person-in-charge of affiliates within China and company executives who travel to China. In addition, the non-compliant company will quickly find out how fragile its business in China is – the Chinese authorities can quickly move to shut down the company’s website and all social media channels – given the importance of social media and the internet in most network marketing companies this will effectively shut down a company’s operations overnight.

Many international Network Marketing companies are currently using cross-border e-commerce as a means to circumvent regulatory restrictions on MLM. Basically, international Network Marketing companies operate by selling offshore products or services into China and having the business operate offshore to the maximum extent possible. Many of these companies have been very successful in generating revenue and profit in China; some extremely so – indeed China has become the main market for a number of these companies as they abandon less lucrative markets.

However, these “offshore” Network Marketing companies often fail to take into account the potential fragility of their business in China. They prefer to believe (or possibly pretend to believe) that their offshore model allows them to avoid the PRC’s legal restrictions on Network Marketing. Nothing could be further from the truth. If your business is operating in China then you are required to be compliant in China or risk the serious consequences of non-compliance outlined above. In some cases this will involve obtaining a Direct Sales License in other cases it may involve a fundamental revamping of the business model.

Compliance Challenge

As outlined above one means by which to operate a Network Marketing company legally in China is by obtaining and maintaining a Direct Sales License.

Obtaining a Direct Sales License is in and of itself a challenge and costly: requirements include a security deposit of at least USD 2.9 million and a minimum paid-up registered capital requirement of approximately USD 11.5 million.

However, in addition the Direct Sales Licenses are currently limited to only six product categories, namely:

  • cosmetics (including personal care products and beauty products for face or hair);
  • health food (with Health Food Approval Certificate issued by the competent authorities);
  • sanitation articles (personal hygienic articles and sanitation articles for daily use);
  • health care equipment;
  • small kitchen appliances and utensils; and
  • household appliance.

Companies selling products which do not fit within these six categories will not be eligible to obtain a Direct Sales License or if they engage in sales of products outside of such categories then revenue accumulated from selling such out of scope products may be seized and a fine of up to around USD74,000 may be imposed. In serious circumstance, the Direct Sales License may be revoked.

In addition companies selling supplements or health food or cosmetics will also need to comply with registration or filing requirements.

Tax compliance is a major issue as well for foreign Network Marketing companies selling into China. Chinese citizens are taxed on a global basis, which means there is risk of tax non-compliance when making offshore payments via Payoneer or other ewallet service providers. Furthermore, the foreign Network Marketing company runs the potential risk of being deemed a permanent establishment in China, leading to uncertain potential tax penalties.

The most important compliance challenge for a Network Marketing company is controlling your China affiliates. As most foreign Network Marketing companies have limited on the ground operations in China, it is difficult to monitor what the affiliates are up to and what message they are sending people they are trying to recruit. In addition, as MLM is illegal in China it is important to ensure that the affiliates also do not use “MLM-speak”. Discussions of “downlines” or “legs” are too connected with illegal MLM structures and can blur lines in operations. In addition, the use of Exigo to manage the business is also a red flag for the PRC authorities.

Technological Challenges

As the name implies Network Marketing relies on networks. In 2017 this means using social media and internet to reach out, connect and transact. This can be a challenge for international companies entering the China market as they are confronted in a country with – No Twitter. No Facebook. No YouTube.

It should be noted that although most US social media sites are banned in China, China has a very vibrant and dynamic domestic social media environment. Tapping into social media is crucial for growth within China.

Digital Marketing – Social media is a larger phenomenon in China than in any other country. Over 880 million Chinese are active users of WeChat – a social network that combines messaging your friends with online shopping, mobile banking and even hailing taxis – and Chinese users spend over 40% of their phone time on this app. Beyond the number of active users, Chinese society naturally favors advertising via WeChat over traditional methods, with a social system comprised of close-knit, interlinked communities of family and friends.

WeChat Stores – WeChat can be used to make sales by Network Marketing subsidiaries. The app has just launched ‘WeChat Stores’ – a tool that allows users to sell products through WeChat for commissions. The tool is set to be a hit: over 50% of sales in China in 2017 are made online compared to roughly 10% in 2012. In an interview with Reuters earlier this year, Amway’s president, Doug DeVos admitted that their store model was struggling to keep pace with the shift to online shopping.

What’s Next?

Both the opportunities and the challenges facing Network Marketing companies in China are significant.

The Network Marketing companies that insist upon using their traditional business models have the choice of operating non-compliantly in China and face great risk or wait outside and possibly miss out on a great opportunity.

The Network Marketing companies that have seized the opportunity and operate non-compliantly within China may be building a large, profitable company but this company may be built upon sand and will collapse in an instant. These Network Marketing companies should consider whether they can legitimize their operations by obtaining a Direct Sales License or by restructuring its business operations so as to be compliant with PRC laws.

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A Guide to Doing Business in China

We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

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