Direct Sales in South China: Still Waiting for the

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SUBJECT: Direct Sales in South China: Still Waiting for the
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1. (SBU) Summary: U.S. direct sales companies in Guangzhou
are optimistic that the China market is once again becoming
hospitable to them. A new law issued in December 2005, and
a batch of licenses expected for summer 2006, has brought
direct selling out of the hybrid retail model in which it
was forced to operate since 1998. Nevertheless, companies
will not be content until the government allows "real"
direct selling, which to them means multi-level marketing.
As it currently stands, companies are not permitted to
implement the multi-level, team-based model that they use in
most other countries. The upcoming year will be a period of
wait-and-see, as national and local regulators form a
workable system. End summary.


2. (SBU) Econoff spoke with Amway's Steven Cheng, chief
financial officer for the greater China region; Nu Skin's Ky
Eap, sales director for southern China; and Sunrider's
Patrick Lam, director of art and communications for China,
about the state of South China's direct sales industry.
Avon, the only company to have a direct sales license at the
moment, declined our request for a meeting.

Background on Direct Sales and the Companies
--------------


3. (SBU) China first opened the direct sales sector in the
late 1980s. A proliferation of pyramid schemes and
fraudulent activity, largely by domestic entities, caused a
public uproar in the late 1990s, leading the government to
ban direct sales in 1998. However, the government allowed
ten large direct sales companies to continue to operate as
"change mode companies," but required them to sell from
retail outlets in fixed locations in what one representative
described as a "hybrid system." The government issued two
key regulations on direct selling in 2005 and a new direct
sales law in November 2005. (This came late, as China
agreed to open the direct sales sector by December 2004 in
its WTO accession agreement.) Avon received the first
license to operate in February 2006. Amway, Nu Skin, and
Sunrider all expect to receive licenses this summer.


4. (SBU) The aforementioned companies all sell personal care
products and health supplements, and all of them manufacture
in China. Amway is the largest of the direct sellers, with
RMB 17 billion (USB 2.1 billion) in sales in China in 2004.
It has a presence in 150 cities in China. Sunrider, a
privately held company, has 14 branch offices in China. The
company has operations in 38 countries, but China accounts
for 40 percent of its global sales. Nu Skin, with 165
retail stores in China, has approximately USD 150 million in
annual sales here. Avon, with whom we have met in the past,
has 74 branch offices and had USD 220 million in sales in
China in 2004.

The 2005 Law: Still Not "Real" Direct Sales
--------------


5. (SBU) The most pressing concern for Amway, Nu Skin, and
Sunrider is the requirement that companies use a single-
level marketing (SLM) model. In SLM, only sales agents
receive commissions for their sales. Multi-level marketing
(MLM),by contrast, is characterized by earnings and bonuses
trickling up from salespersons to their team leaders and
supervisors. According to Amway, Chinese law explicitly
prohibits group remuneration for sales, which is the
hallmark of MLM. (Note: After reviewing the text of the
December 2005 law, we cannot find wording that bans MLM.
However, the accompanying "Regulation on Banning Pyramid
Schemes," issued November 2005, includes text that
explicitly prohibits sales commissions going to more than
one person. End note.)


6. (SBU) China's reluctance to institute MLM apparently
derives from its bad experience with pyramid schemes. Amway

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said this fear is unfounded, as the two systems are
distinct. A pyramid scheme is based upon the number of
people recruited, and an agent's income depends on his
ability to headhunt. In legitimate MLM, on the other hand,
commissions are generated from sale revenue, not
recruitment. Amway said 70-80 percent of directs sales
companies worldwide use MLM. Nu Skin has a presence in 43
countries, and only in China do they not use MLM. Sunrider
said China "does not understand" MLM. Cheng said that
China's WTO agreement does not define direct sales as
including MLM, thus authorities can now define it by the SLM
model.

Commission Cap
--------------


7. (SBU) The 2005 law limits sales commissions to 30
percent. Sunrider and Nu Skin complained that the 30
percent commission cap falls below the worldwide average,
which industry observers have put at a little over 40
percent. Amway, however, said its average worldwide
commissions fall between 30 and 35 percent, and does not
view the cap as a problem.

Service Centers and Branch Offices
--------------


8. (SBU) The 2005 direct sales law also requires that
companies set up customer service centers in provinces in
which they operate. None of the representatives could
explain exactly what constitutes a service center under the
law. Amway and Nu Skin said it may be as little as a
person's residence. Depending on the accepted definition,
Nu Skin may end up with 1,000-2,000 service centers in
China, many of which will also operate as retail stores.
Amway has decided to provide a service function in all of
its stores, and will not set up independent service centers.


9. (SBU) In addition, the new law requires that a direct
sales company have a branch office in every province in
which it operates. The role of branch offices is also not
clear, but the representatives said they plan to use them as
centers for distribution, training, and after-sales service.
Sunrider said it is economically "not feasible" to open a
branch office in every province in which it operates, and
said the requirement will slow the growth of the industry.
Amway, on the other hand, does not see the requirement as a
burden, largely because of the company's sizable assets.

Group Gatherings and Training
--------------


10. (SBU) All of the company representatives said China
strictly enforces the requirement that large gatherings be
approved beforehand by authorities. The typical limit is 50
people, though the number depends on whether the meetings
are held at the provincial, municipal, or local levels.
Recruitment drives or team-building events for direct sales
companies can easily involve more than 50 people. Amway
said there is no way around the requirement, and they simply
must be diligent in notifying Chinese authorities. Nu Skin
and Sunrider said they typically organize such events in the
form of concerts in order to more easily alleviate
government concerns.


11. (SBU) In addition, the new law states that trainers must
be employees of the company -- not consultants, as is the
case in many other countries. New sales agents also must
take a government-administered exam before their first sale.
According to Amway, these requirements allow Chinese
authorities to regulate how a company recruits its sales
agents and also what the agents are taught.

Capitalization Requirement
--------------


12. (SBU) The new law attempts to limit the direct sales
sector to large, established companies by setting a high
entry threshold. Under the law, to establish a direct sales

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entity in China, a company must prove registered capital of
at least RMB 80 million (USD 9.9 million) and pay a RMB 20
million (USD 2.5 million) deposit. None of the three
companies expressed reservations about this requirement,
since they all can easily overcome it. Indeed, they even
see it as beneficial, since it limits their competition. Nu
Skin said the high threshold prevents small and unscrupulous
firms from entering the market and "getting in trouble."
Nevertheless, by barring smaller firms, the requirement may
unintentionally lead to illegal underground activity,
including counterfeiting of legitimate products (reftel).

A Transitional Period
--------------


13. (SBU) All of the companies described 2006 as a period of
transition, during which China's regulators will clarify
currently vague areas of the law through public
announcements and selective enforcement. According to
Amway, the Chinese government will not begin enforcing the
new law in earnest until the end of 2006. Nu Skin said the
lack of clarity in regards to how a company operates its
service centers may be by design, as the Chinese authorities
prefer to wait and see where to draw the line. Local
regulators are also uncertain how to interpret the law and
are using this year to seek guidance from central
authorities.

Comment
--------------


14. (SBU) The last eight years have been difficult for
direct sales companies in South China, as they have been
operating in a sensitive environment and under a watchful
eye. Though direct sales companies consider the current
operating environment less than ideal, they are optimistic
that the day will come when MLM is allowed in China. They
are all treading carefully for the time being, however, so
as not to anger regulators and cause further restrictions.
Much will depend on how provincial and local authorities
interpret and enforce the new law, particularly after more
licenses are issued.

DONG