China: PRC Foreign Investment Draft Law: What You Should Know

On January 19, 2015, China's foreign investment regulatory authority Ministry of Commerce ("MOFCOM") released a draft of new Foreign Investment Law ("Draft Law")  (See blog article Comparison Chart re JV Law and Foreign Investment Law Draft for Comments dated February 10, 2015).  This Draft Law is expected to come into force in the next couple of months overhauling the 25-year-old regulatory framework of inbound foreign investment in China (See Unofficial English Translation of the Draft Law by AmCham China).

Case-by-Case Approval is Abandoned

Under the existing legal framework governing foreign investment, each project or entity is subject to approval by MOFCOM or its local counterparts regardless of the investment sector.  In the Draft Law, only those foreign investment projects that fall under the negative list are subject to the governmental approval requirement.1 For those projects or entities that are not on the negative list, foreign investors are allowed to bypass MOFCOM approval and directly register with the respective Administration of Industry and Commerce in the location of the business or the entity.  In this regard, foreign invested enterprises can benefit from the national treatment principle and only follow the PRC Company Law and relevant regulations in the same way as Chinese domestic enterprises.2

In particular, Articles 20 to 26 in the Draft Law introduce the Catalogue of Special Management Measures which will be announced by the State Council at a later time.  This Catalogue of Special Management Measures (the so-called "negative list") identifies investments that are prohibited and or restricted with conditions.  Those foreign investments that fall under this catalogue must apply for approval in advance.

In contrast to the current Catalogue of Industries for Guiding Foreign Investment which outlines the encouraged, restricted and prohibited industries for foreign investment, the Catalogue of Special Management Measures under the Draft Law will more likely become the decisive negative list for foreign investments.

New Information Reporting Obligations3

The Draft Law will subject all foreign investors and foreign invested enterprises to comprehensive information reporting obligations regardless of the investment sector, even though foreign investment that is not on the negative list is exempt from prior approval.  Such information reporting obligations cover: 1) a report completed before or within 30 days of the investment; 2) a report completed within 30 days of change of the investment; 3) an annual report completed before April 30 of each year after the investment; and 4) a quarterly report completed only by those foreign controlled enterprises whose asset amount, sales amount or business income exceeds RMB10 billion, or enterprises with more than ten subsidiaries.

The failure to comply with the information reporting obligations or a misstatement of information submitted will lead to violations of the Draft Law, and with punishment ranging from a fine between RMB50,000 and RMB 500,000, or a maximum fine of 5% of the investment amount, to a one-year imprisonment of the person-in-charge.

The Draft Law does not specify the government obligation and legal liability with respect to confidentiality.  In the annual report, foreign investors are required to provide sensitive information, such as their main products or services, revenues, profits, associated transactions, material litigation, etc.  Business organizations and AmCham China have suggested that the government revise the Draft Law to include confidentiality obligations by government officials.

Stricter National Security Review 

The current rules regarding national security review of mergers and acquisitions of domestic enterprises by foreign investors are general and broad with respect to its scope and contents4.  Article 57 of the Draft Law provides eleven factors5to consider but these factors are still general and leave much discretion to the inter-ministerial Joint Conference established by the State Council.  Also, the Draft Law includes the factor related to foreign investments' impact on the stable operation of the national economy.  There is the potential risk that a purely economic issue will be converted into a national security issue.  A fully competitive market economy should have clear division between national security and economic security rather than a mixture of both.

Further under Article 70 and 71, interim measures and compulsory measures can be taken by the competent foreign investment department of the State Council to eliminate the national security threat or damage from the foreign investment.  For example, parties concerned can be ordered to refrain from or terminate the foreign investment, or to transfer relevant equities or assets.

Additionally, Article 73 could bring more uncertainty because no administrative reconsideration application and administrative lawsuit are allowed to be filed against the national security review decisions.

VIE Issue

The VIE (viable interest entities) structure can be used by a foreign investor who tries to invest in a project that is on the negative list and circumvent prior approval requirements.  The VIE structure can be achieved through exerting a decisive influence on the operations, finance, personnel, technology, etc. of a domestic enterprise via contractual or trust arrangements.  Since the Draft Law brings in the concept of "ultimate control"6, a domestic enterprise controlled by a foreign investor will be treated as a foreign investor, i.e., such investment will be treated as foreign investment and will be subject to either prior approval or reporting obligations.

The Draft Law creates more uncertainty because it does not clarify any grandfather rule for existing VIE investments.  In its interpretations of the Draft Law, MOFCOM released three opinions7 regarding how to decide existing foreign invested enterprises with VIE structure are controlled by domestic investors and therefore not subject to the negative list.  However, the three opinions are brief and do not grant a grace period to an existing VIE investment when it is considered ultimately controlled by a foreign investor and the concerned business is prohibited or restricted in the negative list.

MOFCOM further states that the above three opinions are subject to further study based on public comments solicited.

Other Issues

Moreover, the Draft Law is expected to cause further reform of China's foreign exchange regulatory framework in respect of inbound foreign investment.  China's foreign exchange regulatory authority, State Administration of Foreign Exchange ("SAFE"), has a strict control over foreign exchange under capital account.  Based on prior MOFCOM's approval of the establishment, capital increase, share transfer and liquidation of a foreign invested enterprise, SAFE then applies its own approval requirements on the inflow and outflow of foreign exchange, the settlement of foreign exchange and the usage of foreign exchange.   Since the Draft Law eliminates the prior admission approval of foreign investment projects that are not on the negative list, will SAFE also loosen its foreign exchange control over such investments?

Looking Ahead

The deadline of soliciting public comments of the Draft Law was on February 17, 2015.  We will keep a close eye on MOFCOM's subsequent actions over this Draft Law and also monitor any change of rules by other regulatory authorities of foreign investments.

Footnotes

1 Compared with the current PRC Sino-Foreign Equity JVs Law, the Draft Law does not use the percentage of investment (25%) to define a foreign invested enterprise.  Rather, Article 14 of the Draft Law treats an enterprise with any amount of foreign investment as a foreign invested enterprise.

2 For example, currently, the business category of foreign invested enterprises in their business license are characterized with either sino-foreign equity JVs (中外合), or sino-foreign cooperative JVs (中外合作) or wholly-foreign owned enterprises (外商独).  Article 157 of the Draft Law requires currently existing foreign invested enterprises to change the category of their registered business with the Administration of Industry and Commerce within three years after this Draft Law comes into effect.  By then, foreign invested enterprises can register their business category in the same way as domestic enterprises such as ABC Limited Liability Company or ABC Company Limited by Shares.

3 Before this new requirement, the State Administration of Industry and Commerce had its own information reporting requirements for foreign investments, such as the basic information of both the foreign investor and the foreign invested enterprise.

4 Notice of the General Office of the State Council on the Establishment of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors issued in 2011 provides that national security review covers foreign investors' mergers and acquisitions of domestic military industrial enterprises and supportive military industrial enterprises, enterprises surrounding major and sensitive military facilities, and other entities relating to the national defense security; foreign investors' mergers and acquisitions of domestic enterprises relating to important agricultural products, important energies and resources, important infrastructural facilities, important transportation services, key technologies, manufacturing of major equipment, etc., which relate to the national security, and whose actual controlling power may be obtained by foreign investors.  Additionally, factors to be considered in a national security review includes influence of M&A transactions on the national defense security, including the ability for producing domestic products and providing domestic services required for national defense and the relevant equipment and facilities;  the influence of M&A transactions on the stable operation of the national economy; the influence of M&A transactions on the order of basic social life; and the influence of M&A transactions on the capacity of research and development of key technologies involving national security.

5 (1) its impact on national defense security, including the impact on the capacity for producing domestic products and providing domestic services needed for national defense, the impact on relevant equipment and facilities needed for national defense, and the impact on the safety of key and sensitive national defense installations; (2) its impact on the research and development ("R&D") capacity of key technologies involving national security; (3) its impact on China's technological leadership in fields involving national security; (4) its impact on the proliferation of dual-use items and technologies subject to import and export control; (5) its impact on China's critical infrastructure and key technologies; (6) its impact on China's information and network security; (7) its impact on China's long-term demand in terms of energy, grains and other critical resources; (8) whether matters of the proposed foreign investment are controlled by a foreign government; (9) its impact on the stable operation of the national economy; (10) its impact on public interests and the public order; and (11) other factors necessary to be considered in the opinion of the Joint Conference.

6 Article 18 of the Draft Law provides that a party shall have control over an enterprise when it meets any of the following circumstances: (1) where the party directly or indirectly holds 50% or more of the shares, equity, property shares, voting rights or other similar rights and interests of the subject enterprise; (2) where the party directly or indirectly holding less that 50% of the shares, equity, property shares, voting rights or other similar rights and interests of the subject enterprise, but falls under any of the following circumstances: a. the party is entitled to, directly or indirectly, appoint at least half of the members of the board of directors or a similar decision-making body of the subject enterprise; b. the party has the ability to ensure that its nominated persons can obtain at least half of the seats on the board of directors or a similar decision-making body of the subject enterprise; or c. the voting rights to which the party is entitled are sufficient to exert a material impact on the resolutions of the shareholders' meeting, the general meeting, the board of directors or other decision-making bodies of the enterprise; (3) where the party is able to exert a decisive influence on the operations, finance, personnel, technology, etc. of the subject enterprise through contracts, trust or other means.

7 (1) foreign invested enterprises with VIE structures who report to MOFCOM that they are ultimately controlled by domestic investors can keep the VIE structure and continue their business; (2) foreign invested enterprises with VIE structures should apply for MOFCOM's confirmation that they are ultimately controlled by domestic investors and only after MOFCOM's confirmation can they keep the VIE structure and continue their business; (3) foreign invested enterprises with VIE structures should apply for admission approval at MOFCOM and MOFCOM together with other relevant departments will make a decision based on factors such as who the ultimate controller of this foreign invested enterprise is.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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