On January 19, 2015, the Ministry of Commerce of the People’s Republic of China (MOFCOM) released a draft Foreign Investment Law (the Draft Law) for public comments, together with an official explanation of the Draft Law (the Explanation). The Draft Law, if adopted, will fundamentally change the landscape of the foreign investment regime that has been in place for over three decades in China. We set out below an overview of the major changes that the Draft Law introduces to the foreign investment regime, including the potential implications for variable interest entity (VIE) which has been the prevalent investment structure for foreign investors in restricted sectors of the Chinese economy.
Negative List and National Treatment
The Draft Law implements a new regulatory model of “pre-entry national treatment” together with a “negative list” regarding foreign investments. Under the decades-old foreign investment regime, all foreign investments are subject to the Industry Catalogue for the Guidance of Foreign Investments (the Investment Catalogue). The Investment Catalogue classifies industries into the “encouraged,” “restricted” and “prohibited” categories; industries not specified in the Investment Catalogue are treated as “permitted.” Under the current regime, an entry license from MOFCOM must be obtained for all foreign investments, even for those in the “encouraged” and “permitted” categories.
Under the Draft Law, as a material departure from the current regime, an entry license is required only for industries that fall under the “restriction catalogue” set out in the Catalogue of Special Management Measures (the Negative List); foreign investors enjoy “pre-entry national treatment” in industries falling outside the Negative List where no entry license is required. Industries in the “prohibition catalogue” remain closed to foreign investors. The Negative List carries similar characteristics as the Investment Catalogue. Once the Negative List replaces the Investment Catalogue, only foreign investments in “restricted” industries must obtain an entry license. As such, the extent to which the prior approval requirement is lifted depends on the specific industries that will be included in the Negative List. The State Council is responsible for formulating the Negative List.
Unified Corporate Form and Governance
Under the current regime, enterprises in which there is foreign investment are called foreign invested enterprises (FIEs). FIEs generally come in three forms: equity joint venture (EJV), contractual joint venture (CJV) and wholly foreign owned enterprise (WFOE). Each corporate form is governed by its corresponding body of laws (the FIE Laws). Inconsistency and, at times, conflicts among the FIE Laws and the Company Law, have caused confusion. The Draft Law solves this problem by abolishing the three corporate forms of FIEs. All FIEs will have the same corporate form as domestic enterprises. That would generally mean a limited liability company, a company limited by shares or a partnership as the choice of entity. The FIE Laws will be repealed after the Draft Law comes into effect. As a transitional arrangement, existing FIEs will have three years to change their corporate form and governance structure.
Codified National Security Review
Acquisitions by foreign investors in specified industries such as military, agriculture, energy, infrastructure, transport and technology are subject to national security review under a circular issued by the State Council in 2011 (the 2011 Circular). The Draft Law not only codifies the national security review regime for the first time, but also expands its scope. Under the Draft Law, national security review can be triggered by any form of foreign investment in an industry that “endangers or likely endangers national security;” it is not limited to acquisitions where foreign investors acquire control of a domestic enterprise or invest in a particular industry.
National security review is not mandatory, however. The Draft Law adopts a voluntary reporting regime. Foreign investors who are concerned about national security implications of a proposed investment should submit an application, together with supporting documents, to the relevant foreign investment authorities for a national security review. However, the relevant foreign investment authorities may at their own initiative launch a national security review when any relevant authorities, industry associations or enterprises in the same industry raise national security concerns. While voluntary, the consequences to one’s failure to secure national security clearance can be drastic. Proposed or consummated foreign investments without national security clearance, if applicable, can be subject to orders to refrain from making such investment, terminate such investment or divest certain equities or assets of such investment.
If foreign investors conceal relevant information or provide false information during the national security review, the relevant foreign investment authorities may impose fines of up to RMB1 million or 10 percent of the investment amount and may request another round of national security review.
Post-Investment Reporting Regime
The Draft Law abolishes the general requirement that prior government approvals be obtained for all foreign investments. Instead, only an administrative, informational filing needs be made prior to or within 30 days of an investment. Hence, a post-investment filing is expressly contemplated. After the initial investment, major changes to an FIE such as share transfer, pledge, and capital increase which require prior approval under the current regime, must be reported within 30 days after they occur. In addition, foreign investors in compliance with periodic reporting obligations must file an annual report each year. Large FIEs with total assets, sales or revenues in excess of RMB10 billion or more than 10 subsidiaries in China are required to file reports on a quarterly basis. The consequences for non-compliance with such reporting obligations can be severe: beyond monetary fines on the FIEs, the responsible persons may be held criminally liable.
Implications for VIEs
Under the Draft Law, foreign investors’ control of domestic enterprises via a VIE structure is explicitly captured as a form of foreign investment. This is a historic development in China’s legal reform because, for the first time, there is formal legislative pronouncement in this grey area. The VIE structure is the prevalent investment structure adopted by foreign investors over the last decade to circumvent restrictions on foreign investments in particular industries, most notably telecommunications. Under a typical VIE structure, a foreign entity controls the onshore operating entity which holds the necessary licenses to conduct the core business. Control is achieved by a series of contracts, without giving the foreign entity direct ownership in the onshore operating entity. If adopted as currently drafted, foreign investors may no longer be able to make foreign investments via VIE in a restricted industry without an entry license.
There is a fair degree of uncertainty regarding the implications of the Draft Law on the VIE structure. One of the notable ambiguities is the meaning of “control.” Under the Draft Law, if Chinese investors control a foreign entity, the foreign entity will be treated as a domestic company and will not subject to the foreign investment regime. The Draft Law defines “control”1 broadly, including de facto control.2 The Draft Law further provides that a foreign entity that is controlled by Chinese investors, when making a restricted investment, shall apply to be treated as a Chinese investor at the same time that it applies for an entry license. As such, the scope of restricted industries in the Negative List will have a significant impact on the VIE structure.3
- Options for Existing VIEs
As to the future of existing VIEs, the Explanation offers three proposals: (i) VIEs that are actually controlled by Chinese investors shall report to the relevant foreign investment authorities, the contractual arrangement may continue and the onshore operating entity may continue to undertake its business activities; (ii) VIEs shall apply to the relevant foreign investment authorities for confirmation that they are subject to the actual control of Chinese investors and, upon receipt of such confirmation, the contractual arrangement may continue and the onshore operating entity may continue to undertake its business activities; and (iii) VIEs shall apply to the relevant foreign investment authorities for an entry license and the relevant foreign investment authorities will decide based on an overall evaluation of the actual control and other factors. MOFCOM will further analyze these options based on public comments.
The Draft Law, if adopted, would bring radical changes to the foreign investment regime in China. While there are ambiguities that await further clarification, the Draft Law is a significant step forward in China’s continuing legal reform. We will continue to closely monitor developments in this important area.
The Draft Law defines “control” as follows: (1) directly or indirectly holding 50 percent or more of the shares, equity, property shares, voting rights or other similar rights and interests of an enterprise; (2) despite holding less than 50 percent of the shares, equity, property shares, voting rights or other similar rights and interests of an enterprise, (a) being entitled to directly or indirectly appoint at least half of the members of the board or a similar decision-making body; (b) being able to ensure that its nominees obtain at least half of the seats on the board or a similar decision-making body; or (c) being able to exert a material impact on the resolutions of the shareholders meetings or the directors meetings; or (3) being able to exert a decisive influence on such matters as the operations, finance, personnel, and technology of an enterprise through contracts, trusts or other means.
2One can think of a variety of scenarios where control may be called into question. For example, it is not clear who would be deemed to control a foreign entity if foreign and Chinese investors have equal shareholdings. It is also difficult to determine control if foreign investors hold more than half of the voting rights of the foreign entity when, concurrently, Chinese investors can exert a decisive influence on its operations, finance, personnel, and technology.
We note that the Draft Law does not mention prohibited industries. To the extent its omission is intentional, it would appear that a foreign entity that is controlled by Chinese investors would still be not treated as a “true” domestic company.
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