Shanghai (Blackstation/Getty Images)

With its dense skyline, pulsing streets and cosmopolitan vibe, Shanghai never fails to remind visitors of another noncapital world city. “Shanghai is New York!” says Allbright Law Offices partner Victor Wang, describing the popular perception in the West. And he agrees that the cities are alike in terms of their look, feel and attitude.

But, despite hosting China’s largest stock exchange, Shanghai simply doesn’t compare as a financial—or legal—center. Not to New York, not to Hong Kong, not even to Beijing. To some international firms, a Shanghai office has become expendable. Vinson & Elkins closed theirs last year, and Wall Street firms such as Sullivan & Cromwell, Simpson Thacher & Bartlett and Davis Polk & Wardwell never even bothered to open there. Among domestic firms, Wang acknowledges that those originating from Shanghai, of which Allbright is the largest, have fallen behind Beijing firms like King & Wood Mallesons, Jun He Law Offices and Zhong Lun Law Firm, in terms of both reach and reputation.

The Chinese government’s tight control of 
the economy means that the biggest transactions—initial public offerings, overseas mergers and acquisitions—flow mostly through the capital,
 not Shanghai. “People assume that Shanghai is the business center while Beijing is the political center,” says Skadden, Arps, Slate, Meagher & Flom Shanghai partner Gregory Miao. “That doesn’t really reflect the reality.”

But lawyers and firms not so heavily focused on capital markets or outbound M&A say Shanghai is anything but dispensable. The city remains the preferred location for multinational corporations’ China headquarters, and Beijing’s recent well-publicized livability—and breathability—issues may only strengthen that preference. Shanghai-based lawyers also note that the region is home to a large proportion of China’s private enterprises, which are expected to continue to grow and eventually challenge SOEs in many sectors.

Those private companies would be helped by more favorable government policy, as would Shanghai’s ongoing quest to become a more important financial center. A recently announced suburban free trade zone may be a start, but most lawyers think much more needs to change.

Which means Shanghai’s future as a top-tier legal market will depend, to a large degree, on political decisions made in Beijing.

Shanghai, one of the treaty ports forced open by the British during the 19th-century Opium Wars, was China’s most important center for trade and finance in the early part of the 20th century, when foreign powers held sway under the extraterritorial rights they had extracted. The art deco and neoclassical architecture left behind from this period remain some of Shanghai’s most striking sights; last year Jones Day moved its offices into one of the historic buildings along the Bund, the city’s famed waterfront promenade.

The Shanghai that those buildings represent faded with the onset of war with Japan in the 1930s and the Communist revolution in 1949. After that, economic power shifted heavily to the state, and it has stayed there.

In China today, regulatory approvals are essentially make-or-break for big deals. Foreign acquisitions need to pass muster with the Ministry of Commerce, including its antimonopoly bureau. Overseas acquisitions by Chinese companies could require sign-off by the China Securities Regulatory Commission, the State Administration for Foreign Exchange and, in the case of state-owned enterprises, the state-owned Assets Supervision and Administration Commission, or the National Development and Reform Commission. All of these agencies are based in Beijing. The CSRC also directly governs China’s two stock exchanges in Shanghai and Shenzhen, and gaining the regulator’s approval is the major focus of capital markets practice in China.

But its regulatory authority is not the only way the Chinese government runs the economy. Virtually all of the 73 Chinese companies that made Fortune’s Global 500 in 2012 were state-owned enterprises. Of these, 44 were headquartered in Beijing, including nine of the top 10. Only six of the Global 500 companies were based in Shanghai, most of which were also SOEs.

David Tang, another Allbright partner, says the major Beijing law firms are simply much more plugged into the SOEs than their Shanghai counterparts. “The principal partners at those [Beijing] firms tend to have relationships with the government officials, whether they are classmates or friends,” says Tang. “Those kinds of relationships give them lots of benefits and a better chance to work with the SOEs.”

International firms also want in with the SOEs, which have the strong backing of the Chinese government to make acquisitions abroad and have therefore led the much-touted China “outbound” wave of recent years. One SOE, China National Offshore Oil Corp., was behind the largest China outbound deal ever when it acquired Canada’s Nexen Inc. for $18 billion last year.

Xiao Yong, head of the China practice for Vinson & Elkins, says his firm’s move to a strongly outbound focused practice—the firm is a market leader in representing Chinese state-owned energy companies on overseas deals—made a Shanghai office superfluous. “We found that 90 percent of our leading clients were in the Beijing area,” he says of the firm’s decision last year to close in Shanghai and consolidate its China practice in Beijing and Hong Kong, where global financial institutions generally have their Asian headquarters.

The Chinese government has frequently said that it wants to make Shanghai an international financial center on par with Hong Kong, New York and London. In 2009 the State Council declared this would be accomplished by 2020. But most watchers see little progress to date. “We’re not betting on that at all,” says Miao. “A robust financial market really needs to have a totally independent and very sophisticated judicial system to support that. Unless China can change its policy to create that, Shanghai is not going to become a meaningful financial center. Compared to what Hong Kong has, what Singapore has, it lacks that fundamental infrastructure.”

U.S. firms advising Chinese companies on capital markets mostly stick to Hong Kong and Beijing. “We sometimes do deals out of Shanghai, but not having an office there doesn’t seem to have hurt us,” says Leiming Chen, a Simpson Thacher & Bartlett partner in Hong Kong.

But though a handful of international firms may have left or stayed away, there’s hardly a shortage of them in the city. Last fall, Clifford Chance marked 20 years in Shanghai, and most of the other Magic Circle firms also have offices there. Of the 20 highest-grossing firms in The American Lawyer’s Am Law 100, 15 have Shanghai offices. For several major U.S. firms, including Kaye Scholer, Pillsbury Winthrop Shaw Pittman and Greenberg Traurig, Shanghai is the only office they have in China.

And more international firms keep coming. Chicago’s Seyfarth Shaw opened an office last year. So did Tokyo’s Anderson Mori & Tomotsune, while Dallas’ Haynes & Boone and Atlanta’s McKenna Long & Aldridge announced plans to do so when they receive regulatory approval.

Those firms are choosing Shanghai because that’s where their clients from home are going. If the biggest Chinese companies are overwhelmingly based in Beijing instead of Shanghai, the reverse seems true for their foreign counterparts. Around 400 multinationals, including such titans as The Coca-Cola Company, McDonald’s Corporation, and The Walt Disney Company, have their regional headquarters in Shanghai. By comparison, Beijing hosts around 120.

Advising such companies on their Chinese investments and operations—so-called inbound work—used to be what all international law firms did in China, whether in Shanghai or Beijing. “Outbound was nothing five years ago,” says King & Wood Mallesons Shanghai partner Mark Schaub. “It’s become a bigger thing now.” But inbound is still most Shanghai-based lawyers’ bread and butter. “My practice is probably 70 percent inbound work,” says Kirkland & Ellis Shanghai partner Samuel Williamson. “For Kirkland, our client base has a strong aspect of large U.S. publicly traded companies. Some of them have their headquarters in Beijing, but more of them seem to be here. That’s why it’s made sense for us to be here, to deal with the large pharmaceutical companies, large infrastructure-type companies.”

Kaye Scholer closed its Hong Kong office in 2006, deciding that Shanghai was a better fit for the way its practice was developing. “Do I think it would be even better if we had a dynamite Hong Kong practice and had the name recognition from that?” Kaye Scholer Shanghai managing partner Yingxi Fu-Tomlinson says. “Of course it would be good, but we don’t. That doesn’t mean the game is over.” She notes that Kaye Scholer’s traditional client base is made up of companies from the northeastern United States. In Shanghai, the firm recently represented The Hershey Company on the launch of its new Lancaster soft caramel candy, the company’s first new product in decades, which it decided to introduce in China first. Kaye Scholer also advised Lutron Electronics Co. Inc. on its winning bid to provide window shades for Shanghai Tower, the 2,073-foot skyscraper now rising over Shanghai’s Pudong district that will be the world’s second-tallest building when it’s finished later this year. Both Hershey and Lutron are based in Pennsylvania. “Where we see ourselves is in the more substantive industry sector,” says Fu-Tomlinson. “The financial sector and capital markets aren’t our strengths.”

Skadden has a Shanghai office because the biggest inbound M&A deals are still worth fighting for, Miao says. “The typical New York firms are only focusing on capital markets,” he says, “but we’ve been trying to have a more diversified practice.” For deals of such magnitude, Miao says, the acquirers prefer to use a top-tier transactional firm, provided it’s in close proximity. “I’d say we’ve picked up most of our Shanghai-based deals by American companies and PE firms because we had an office here,” he says.

In 2009 Skadden represented Coca-Cola in its attempt to buy Huiyuan Juice Group for $2.4 billion, a deal that would have been the largest foreign acquisition in the country ever but was controversially scuttled by China’s antitrust regulators in one of their first outings. Miao says Skadden probably would not have been hired by Coke if it didn’t have a Shanghai office. “We were never on their [law firm] panel before,” he says “This was entirely a Shanghai initiative—only a few lawyers from Atlanta [where Coke is based] were involved, and a handful of people in Hong Kong did some execution work.”

Like their foreign counterparts, Chinese firms in Shanghai mainly represent multinationals, and they have done well by doing so. Wang ticks off BP plc, General Electric Company and Abbott Laboratories as regular clients of Allbright. He figures the 750-lawyer Shanghai firm is comparable to its Beijing rivals financially but definitely lags behind when it comes to practice management and integration, branding and footprint.

The growth in capital markets and outbound Chinese investment explains much of the divergence. The cross-border merger that led to King & Wood Mallesons was driven in large part by a desire to create a “Chinese” firm that could advise Chinese companies as they expanded around the world. Aside from the large general practice firms, Beijing has also spawned corporate boutique firms like Jingtian & Gongcheng and Haiwen & Partners that focus heavily on capital markets practice before the CSRC.

But Wang and Tang also credit Beijing firm leaders like King & Wood Mallesons chairman Wang Junfeng and Zhong Lun founder Zhang Xuebing for undertaking reforms that have created more integrated firms. While most Shanghai firms still face challenges getting partners to work together rather than competing for business, King & Wood Mallesons’ Wang moved his firm to a partial lockstep compensation system and put in place systems designed to encourage collaboration. “We admire them,” says Victor Wang. “Their vision and their leadership have been essential to their success.”

That success has been noticeable on Shanghai firms’ home turf. Allbright’s biggest competitors are now mainly not other Shanghai firms but the local branches of Beijing firms.

Wang and Tang are part of a group of Allbright partners trying to push their firm in a similar direction. In November, Allbright opened a Hong Kong office, its first outside mainland China. But Tang, a Shanghai native who joined Allbright in 2010 from Pillsbury Winthrop, says there are also traits associated with each city that help explain the different paths their lawyers have taken. “Most Shanghai lawyers focus more on technical things,” he says. “They’re more pragmatic than visionary.”

King & Wood Mallesons’ Schaub, one of the first Western partners to join that firm, puts it more directly. “People in Beijing want to build a big thing,” he says. “People in Shanghai just want to get rich.”

Multinationals aren’t the only draw in Shanghai. The greater area, including neighboring Zhejiang and Jiangsu provinces, has proven a hotbed for private enterprise, including one of China’s greatest private industry success stories. Hangzhou-based e-commerce giant Alibaba Group is currently planning what is expected to be the biggest tech IPO since Facebook.

Brad Peck, head of Cooley‘s China practice, says the Silicon Valley firm chose Shanghai for its first office in the country mainly to try to reach small, early-stage Chinese companies. “We had a perception that Shanghai had more of that community, especially in the life sciences,” he says. Of course, Beijing is not bereft of such companies either. With most of China’s top universities, Beijing has a research and education infrastructure that has also attracted large number of private tech start-ups, including domestic Internet giants Baidu Inc. and Inc. The fact that many of Cooley’s major U.S. venture capital clients chose Beijing as their base made the firm’s decision a tough one.

“I wouldn’t say it was a coin flip, but it was that close,” says Peck. He says the firm does cover both markets out of Shanghai, but it’s a challenge. “We definitely didn’t get two for the price of one,” he says. “We have to work harder to get to Beijing.”

Several other Shanghai-based lawyers also say their practices aren’t limited to one market. Andrew Ruff, a partner with Shearman & Sterling, says his firm opened an office in Shanghai in large part to demonstrate its strong commitment to the China market in general. But his own project finance practice takes him all over China. “I don’t know that we look at Shanghai as the Shanghai market as much as we just look at it as another foothold in the China market and platform for doing work here or in Beijing or wherever,” says Ruff. “This is where I live. Where I work is where the deals are.”

Where their people want to live in China is not an insignificant consideration for firms, as well as other international businesses. Ruff, a New Yorker, says he much prefers living in dense Shanghai over Beijing with its concentric sprawl. “It’s a fascinating place to visit,” says Ruff of Beijing. “But it’s really badly polluted and, to me, the civic design doesn’t seem conducive to everyday life. You feel like you’re constantly in a traffic jam and it’s never going to end.”

Other lawyers also feel strongly on that point. “I would refuse to live in Beijing,” says Schaub, who has lived in Shanghai for 15 years.

Though Shanghai’s air is by no means pristine, it has yet to experience an “airpocalypse” like Beijing did last January, when measured air quality was 40 times the level considered hazardous by the World Health Organization. Some expect the trend of multinationals favoring Shanghai to intensify as a result. “I just had a client—a big hospitality company—call me the other day,” says Kaye Scholer’s Fu-Tomlinson. “She was saying the air pollution in Beijing is so bad they were thinking about moving their office as an employee benefit.”

But, as long as China remains the way it is, most Shanghai lawyers acknowledge that Beijing will have an edge for the most consequential work in China. “The chop is there,” says Fu-Tomlinson, referring to the carved seals often used in China to stamp official documents. “People congregate where the chop is.”

Still, there are signs that the Chinese government may be willing to devolve some power. Ruff says a number of officials have spoken about the importance of encouraging private enterprises. “Innovation is the watchword,” he says. “There are fears the SOEs may be smothering the economy.”

Indeed, that was the main thrust of policy statements issued during the Third Plenum of the 18th Central Committee, a major Communist Party confab held in November. Announced by the government in July and opened in September, Shanghai’s Waigaoqiao Free Trade Zone has been hailed by some as a possible vanguard for future reforms. The idea is that companies will be able to operate in this FTZ without the myriad approvals and checks needed elsewhere in China, resulting in a more level playing field between foreign and domestic enterprises, as well as public and private businesses. Premier Li Keqiang, the project’s godfather, has hailed the FTZ as a possible laboratory for future liberalization of the Chinese economy, especially the financial sector.

But not everyone in the Chinese government is eager to see that happen, and Li reportedly continues to face strong resistance to his plans for the FTZ from the CSRC and other quarters of the state bureaucracy. As a result, the exact range of the FTZ’s freedoms remain unclear, though certain industries like gaming and news media have already been barred from the zone. “[The FTZ] can only be a plus for Shanghai,” says Kirkland’s Williamson. “The question is how much of a plus. It’s sort of unclear what the scope of it is and how companies are going to participate in it. And how do you project the benefits of the free trade zone outside the free trade zone? These are the questions no one has the answers to yet.”

The answers will depend on how far the Chinese government is really willing to go. But whether the FTZ proves a catalyst or not, Schaub says the future favors Shanghai. “The advantages Beijing has is that they’ve got the MOFCOM, they’ve got the antitrust, they’ve got the CSRC, they’ve got all that regulatory stuff,” he says. “But it depends if you believe in regulation or free enterprise. If you’re looking for healthy development, I think it’s here.”