On January 19, 2015, the Ministry of Commerce (MOFCOM) of the People's Republic of China (PRC) published a draft bill of the Foreign Investment Law for public comment (the Draft FIL),1 revealing an upcoming overhaul of the existing foreign investment laws. In this WSGR Alert, we provide an overview of the legislative background of and major changes contemplated by the Draft FIL, which is expected to reshape the decades-old foreign investment regime in China.
China's first foreign investment-related law, the Sino-Foreign Equity Joint Venture Law (EJV Law), was promulgated in the late 1970's when China first lifted the curtain on foreign capital inflows. The Sino-Foreign Contractual Joint Venture Law (CJV Law) and the Foreign-Invested Enterprise Law (FIE Law) were promulgated shortly after. Subsequently, the EJV Law, the CJV Law, and the FIE Law (together, the Existing Laws) formed the three pillars of the existing regime that regulates not only foreign direct investments (FDI) in China, but also China-inbound cross-border mergers and acquisitions (M&A), corporate finance, and capital markets transactions.
Over the years, however, the Chinese economy has significantly outgrown the provisions of the Existing Laws. Also, there is apparent inconsistency between the corporate governance framework under the Existing Laws and the framework under the amended PRC Company Law promulgated in 2005, which creates differential treatment of foreign-invested companies and domestic companies, even though both are incorporated in the PRC.
In the past few years, rules regulating other aspects of foreign investments have also evolved, as illustrated by the adoption of the PRC Anti-Monopoly Law and the establishment of the national security review system. The introduction of the Draft FIL is a significant and necessary move by the PRC government to overhaul the existing foreign investment rules and reconcile the interplay between them through a unified approach.
Reduced Governmental Approval Formalities
The Existing Laws require regulatory approvals for various routine yet fundamental corporate actions by foreign-invested companies, such as incorporation, dissolution, capital increase or decrease, and transfer of equity interests, which creates a significant burden for FDI and M&A transactions involving any foreign-invested company. For each of these corporate actions, a foreign-invested company is required under the Existing Laws to obtain approval from the Commerce Committee (MOFCOM's counterparts at the applicable provincial, municipal, or other local levels), while a domestic company is not required to go through such process at all. Also, the approval process primarily involves non-substantive reviews that largely overlap with the administrative registration process of the Administration of Industry & Commerce (the authority in charge of corporate registries), which applies equally to foreign-invested companies and domestic companies alike. In contrast, under the Draft FIL, no case-by-case review and approval would be required for foreign investments unless the investment falls into a negative list of industries that are restricted or prohibited for foreign investors (the Negative List). It is expected that this change, once adopted, would shorten the approval process for many FDI and M&A transactions involving foreign-invested companies by at least approximately 20 days.
The Negative List has not yet been released, but it is generally expected that the final version of such list will be a shorter version of the existing list of restricted and prohibited industries set out in the current Catalogue for the Guidance of Foreign Investment Industries (the Catalogue).2 For example, many commentators, including some MOFCOM officials, expect the Negative List to exclude e-commerce, an industry that was already fully opened up to foreign investors in the Shanghai Pilot Free Trade Zone earlier this year and removed from the proposed amendment to the Catalogue in 2014.3
Foreign investments in restricted industries will continue to be subject to case-by-case review and approval by the Commerce Committee based on restrictions to be set forth in the Negative List. However, the Draft FIL provides the Commerce Committee discretion to "conditionally" approve foreign investments in restricted industries that do not meet the restrictions set forth in the Negative List. In other words, foreign investors may get a green light to make investments in a restricted industry upon the satisfaction of certain conditions specified by the Commerce Committee, such as (a) spinning off certain assets or businesses; (b) limiting foreign ownership to a certain percentage; (c) keeping businesses in operation for a requisite period; (d) limiting investment to certain regions of the country; or (e) achieving a certain quota or quantity in local hiring. Further, the Draft FIL introduces an appeal process for foreign investors to challenge the decisions of the Commerce Committee's market-entry review.
It is worth noting that such discretionary case-by-case market-entry review, however, would not be available to prohibited industries on the Negative List, which remain inaccessible to investors with any foreign ownership.
Emphasis on Substantial Compliance and the Implications for VIE Structure
Certain market practices have been developed to circumvent foreign investment restrictions under the Existing Laws, including the so-called "variable interest entity" structure (VIE structure, also known as the "Sina-Sohu structure") that has been widely adopted among Chinese Internet companies.4
In determining whether an investor can enter a restricted industry, the Draft FIL adopts a substance-over-formality approach in determining whether an investor is a foreign or domestic investor. Following the path under the Company Law and the Anti-Monopoly Law, the Draft FIL adopts a similar substance test in determining whether an entity should be considered a foreign investor. Under the Draft FIL, a PRC-incorporated entity that is ultimately controlled by foreign individuals, entities, or government agencies would be deemed a foreign investor, while a foreign-incorporated entity that is ultimately controlled by PRC individuals or entities may be considered a Chinese-controlled entity and would not be subject to the foreign investment restrictions. Under the Draft FIL, "control" may be deemed to exist in any of the following forms:
direct or indirect ownership of 50 percent or more of the subject entity's shares, equity interests, asset interests, voting rights, or other material rights or benefits;
the right to appoint or the capacity to ensure the appointment of 50 percent or more of the members of the subject entity's board or equivalent authority;
the right to materially influence the decisions of the subject entity's shareholders' meetings, board, or equivalent authority; or
material influence on the business, finance, human resources, or technology of the subject entity through contract, trust, or other arrangements.
This proposed change has triggered certain market concerns over the validity and sustainability of the VIE structure. In a typical VIE setup, certain PRC nominee shareholders (normally the founders, their relatives, or early employees who are PRC citizens or their domestically incorporated entities) will set up a PRC-incorporated operating company (the "VIE Company") to obtain the licenses required to operate certain businesses that are restricted or prohibited for foreign investors (e.g., the Internet content provider license that is required for most Internet companies operating in China). Although the record shareholders of the VIE Company are PRC individuals and/or domestically incorporated entities, the VIE Company is in fact controlled and beneficially owned by foreign investors through contractual arrangements with a wholly foreign-owned enterprise established by such foreign investors. On the surface, such structure is in compliance with the market-entry restrictions under the Existing Laws' formalistic approach, as the PRC operating entity's record shareholders are PRC persons. The Draft FIL's definition of "control," however, covers controls through contractual arrangements and therefore would place the persons that ultimately control the local operating entity under scrutiny. If the ultimate controlling person(s) is/are one or more foreign persons, the VIE Company would be deemed a "foreign investor" as well and therefore be subject to the market-entry restrictions.
The VIE structure has been widely adopted by foreign-capital-backed companies that operate in restricted sectors, especially in e-commerce, technology, media, and telecommunications. Many of them are public companies listed on the United States, Hong Kong, or other overseas stock exchanges, including leading Chinese Internet companies that are symbols of China's new economy. Addressing this type of grandfathered situation is not an easy issue to tackle and the Draft FIL does not provide a definitive answer. In the legislative notes, MOFCOM suggested the following three options for further discussion:
A pre-existing VIE Company may:
remain as is by completing a filing with the relevant government authority to declare its status as a PRC-controlled company;
apply for the authority's determination that it is PRC-controlled so that it can keep its existing VIE structure and continue operations thereunder; or
go through a full market-entry review by the relevant government authority that will make a decision based on the entity's ultimate controlling person(s).
No matter which approach the final FIL adopts from the above options, we believe that a company with an existing VIE structure but which is actually controlled by PRC person(s) should not be overly concerned, although it may still need to go through an endorsement process with MOFCOM to verify its "PRC-controlled" status. For a company with an existing VIE structure that is under de facto control of one or more foreign persons, there are uncertainties as to (i) whether the business it currently operates through the VIE Company will be on the Negative List to be promulgated, (ii) how the "conditional approval" discussed above would play out in practice, and (iii) whether the final FIL will include a blanket "grandfather" provision. Given the PRC government's track record of pragmatism over the last three decades and its tendency to avoid significant disruption to the market, we do not expect that the PRC government would take the abrupt and extreme approach of massive outlaw of pre-existing VIEs. Having said that, we suggest taking extra caution when using VIE structures in new transactions in the near future before the Draft FIL is finalized.
Interplay with the Company Law
Inconsistencies between the Existing Laws and the Company Law have caused confusion among foreign-invested companies in many corporate governance matters. For example, under the EJV Law, an equity joint venture cannot have a shareholders' meeting as its highest decision-making authority, but a shareholders' meeting is the highest authority for domestic companies incorporated under the Company Law. As the Existing Laws will be repealed when the Draft FIL takes effect, all foreign-invested companies will be subject to the corporate governance rules under the Company Law. In other words, all companies incorporated in China, regardless of whether they are domestic or foreign-invested, will be subject to the same corporate governance rules under the Company Law. The Draft FIL also grants pre-existing foreign-invested companies a grace period of three years to comply with the Company Law in that regard.
The Draft FIL is expected to have a significant impact on the application of the Regulations on Mergers and Acquisitions of Domestic Companies by Foreign Investor, also known as the "M&A Rule."5 This regulation, among other things, requires offshore special-purpose vehicles formed for the purpose of an overseas listing and controlled by PRC companies or individuals to obtain approval from the China Securities Regulatory Commission (CSRC) prior to listing their securities on an overseas stock exchange. However, the application of the M&A Rule remains unclear, as CSRC has not issued any definitive rule or interpretation of this regulation since its adoption. In practice, CSRC has not granted approval to any Chinese company under the M&A Rule since its promulgation in 2006. All Chinese companies that went through the so-called "red-chip restructuring" to link the PRC operating entities to the offshore listing vehicle before overseas listing had to include in their prospectuses a risk factor addressing the uncertainty under the M&A Rule. Since the Draft FIL redefines what constitutes a "foreign investor," a concept crucial to the applicability of the M&A Rule, it remains to be seen how such change will play out in the context of the M&A Rule.
National Security Review and Anti-Monopoly Law
Chapter 4 of the Draft FIL codifies the national security review of M&A transactions involving China-based businesses or assets that was first introduced in the Circular on Formalizing Security Review System of Mergers and Acquisitions of Domestic Enterprises by Foreign Investors in 2011.6 The Draft FIL strengthened the connection between the market-entry review and the national security review by requiring the Commerce Committee to suspend the market-entry review process and redirect the applicant to the national security review process whenever any national security concern is identified. The market-entry review may be resumed only after the investor passes the national security review.
Under the Draft FIL, applicants for market-entry review are also required to declare to the Commerce Committee whether a review under the Anti-Monopoly Law would be triggered in their cases. Compared to the existing voluntary reporting system, such universal requirement for mandatory declaration in every market-entry application is a significant development in the implementation of the Anti-Monopoly Law and will heighten the importance of anti-monopoly analysis in M&A transactions involving foreign-invested companies in China.
A New Reporting System
The Draft FIL adopts a new reporting system for the governmental agencies' collection of information on foreign investments for supervision purposes. All foreign investors and foreign-invested companies, whether in an industry covered by the Negative List or not, are required to file the following reports:
Initial report: A basic report to be filed by the foreign investor or invested company prior to or within 30 days after the investment, which needs to contain certain information regarding the investment and the investor;
Report of change: Amendment to the basic report to be filed by the foreign investor or foreign-invested company in connection with changes to the investment profiles within 30 days after the occurrence of such change; and
Periodic report: Annual report containing information such as financial performances of the previous year and assets-related transactions. For a foreign-invested company (i) with total assets, annual sales revenue, or turnover exceeding RMB10 billion, or (ii) having more than 10 subsidiaries, an additional quarterly report covering certain operating conditions and financial information is required.
These reporting requirements should be carefully followed by all existing and new foreign-invested companies since non-compliance may trigger fines and even criminal charges for the companies' management personnel.
As a long-anticipated overhaul of China's foreign investment laws, the Draft FIL is a welcome move to further simplify the regulatory approval process for foreign investments and afford equal treatment to foreign-invested companies and domestic companies. The Negative List to be issued under the Draft FIL should further eliminate or reduce market-entry restrictions for foreign investors in certain industries. Even for industries remaining as restricted on the Negative List, the Commerce Committee will have more discretion in determining whether a foreign investment that does not meet the statutory restrictions may be conditionally approved under case-by-case review system introduced by the Draft FIL. The shift toward a substantive test in market-entry review for foreign investments in the restricted industries should also be a positive development for PRC-controlled, foreign-incorporated companies (even those with pre-existing VIE structures), but its impact on foreign-controlled companies cannot be fully assessed in the absence of a published Negative List and other implementation rules of the Draft FIL. Moreover, we anticipate that certain market practices will evolve in the coming months along with the legislative process of the Draft FIL. We will closely monitor the legislative and market developments and provide updates in future WSGR Alerts.
Wilson Sonsini Goodrich & Rosati is licensed to operate in the People's Republic of China (PRC) as a foreign law firm and in Hong Kong as a Hong Kong solicitors' firm. Our China practice provides U.S. and Hong Kong legal services to clients. Under PRC Ministry of Justice regulations, foreign law firms in China are permitted to advise clients on certain aspects of international transactions and to provide consultation concerning the impact of the PRC legal and regulatory environment; foreign law firms in China are not permitted to practice PRC law. The content of this WSGR Alert does not constitute an opinion on PRC law, nor does it constitute legal advice, but is based on our research and our experience advising clients on international business transactions in China.
1 The original Chinese text of the Draft FIL and legislative notes can be found online at http://tfs.mofcom.gov.cn/article/as/201501/20150100871010.shtml
2 The original Chinese text of the Catalogue (as amended in 2011) is available online at http://images.mofcom.gov.cn/wzs/accessory/201112/1325217903366.pdf
3 Please see the Q&As published by MOFCOM (in Chinese) at http://zcq.mofcom.gov.cn/article/zcqxwdt/201501/1853011_1.html?COLLCC=3668150144&. The proposed amendment to the Catalogue in 2014 (in Chinese) is available online at http://www.sdpc.gov.cn/gzdt/201411/t20141104_647352.html
4 The VIE structure was introduced in the late 1990’s in response to the restriction on foreign investments in Chinese companies that engaged in value-added telecommunication services, including publishing contents on the Internet for commercial purposes. It was first adopted by Chinese Internet portal companies such as sina.com and sohu.com.
5 The original Chinese text of the M&A Rule (as amended in 2009) is available online at http://www.mofcom.gov.cn/article/b/c/200907/20090706416939.shtml.
6 The original Chinese text of the circular is available online at http://www.mofcom.gov.cn/article/b/f/201102/20110207403117.shtml.