On January 19, 2015, the Ministry of Commerce (MOFCOM) of the People's Republic of China (PRC) published a draft law called the Foreign Investment Law of the PRC and began to solicit public comments thereon. MOFCOM also published a document explaining its legislative intent and key provisions.
Currently, there are three key legislations governing foreign-invested enterprises (FIEs): the Sino-Foreign Equity Joint Venture Law (EJV Law), the Sino-Foreign Contractual Joint Venture Law (CJV Law) and the Wholly Foreign-Owned Enterprise Law (WFOE Law). These laws, as well as their amendments and implementing rules and regulations,1 together form a distinct body of law for foreign investors in China. Once the draft law becomes effective through legislative process, the EJV Law, the CJV Law and the WFOE Law will be abolished.
These three laws, promulgated in the late 1970s and the 1980s, have led to some issues for regulators, adjudicators and investors. They are enforced by different government agencies without much inter-agency coordination, and there are conflicts and inconsistencies between them and the PRC Company Law promulgated in 1993 (which applies to all PRC companies incorporated as limited liability companies or joint stock companies, including FIEs) in terms of corporate governance, share transfers, capital requirements and so forth. MOFCOM has been tasked with drafting the Foreign Investment Law to resolve these issues and bring all types of foreign investments into one consolidated framework to supplant the EJV Law, the CJV Law and the WFOE Law.
A. Executive summary
There are six key changes proposed in the draft law:
- The draft law has broadened the definition of "foreign investment" and adopted the principle of "substance over form" by introducing the concept of "control" by looking through the shareholding structure or contractual arrangement and at the nationality of the ultimate controlling person or entity. For instance, if a foreign investor incorporates a wholly owned or controlled company in China which in turn invests into other domestic companies, such investment would be treated as "foreign investment" as the ultimate controlling person is foreign.
- The EJV Law, the CJV Law and the WFOE Law will be abrogated once the draft law is adopted and the FIEs would need to comply with the corporate governance requirements under the PRC Company Law or the PRC Partnership Law, as applicable.
- New foreign investments in industries outside the "negative list," a special catalogue to be published by the State Council, will enjoy the same national treatment as domestic companies in terms of market entry. In other words, a foreign investor will no longer be required to obtain prior approval of MOFCOM to set up a new company in industries outside the "negative list." Such a foreign investor may apply for business licenses directly with the company registration agency just like any Chinese investor. Foreign investments in restricted industries on the "negative list" are subject to prior approval from MOFCOM based on MOFCOM's review of the nature of the investment from public interest perspective rather than the contracts underlying such investment.
- Foreign investors are required to apply for national security review on voluntary basis while at the same time the government may initiate the national security review on its own. However, there is no clear guideline in the draft law as to when a foreign investor should proactively apply for such review and what would constitute a threat to national security.
- The draft law has adopted a comprehensive information reporting system, which may increase existing foreign investors' operating costs in China.
- Further, the nationality of the ultimate controlling owner would determine the nature of the so-called "variable interest entity" (VIE) structures. VIE structures could no longer be used to circumvent the restrictions on foreign investments once the draft law is adopted.
B. Key changes proposed in the draft law
1. Definition of foreign investment and foreign investor
The draft law defines "foreign investment" much more broadly under the draft law than in the existing regulations, and includes: (i) establishing domestic enterprises; (ii) obtaining equity interests, shares of property, voting rights or similar rights and interests of domestic enterprises; (iii) providing financing with a term of more than one year to the aforementioned domestic enterprises; (iv) obtaining concession rights relating to exploitation or development of natural resources in the PRC or construction or operation of infrastructure projects in the PRC; (v) obtaining domestic land use rights, housing ownership or other rights to immovable property; and (vi) obtaining control of domestic enterprises or the equity interests in domestic enterprises through contractual or trust arrangements. Importantly, this last item suggests that the VIE structures used to circumvent the approvals of foreign investments in restricted industries would be brought under regulatory oversight.2
The draft law defines "foreign investor" to include, among others, domestic enterprises controlled3 by foreign investors. Investments made by such domestic enterprises would be treated as foreign investments and regulated under the Foreign Investment Law. "Control" is defined to include both the situations when an investor holds more than 50 percent of the voting power of a company and when an investor holds less than 50 percent of the voting power but has the power to influence the decision making body of a company. It is unclear whether a company will be treated as an FIE if a company is jointly controlled by several investors, some of which are foreign investors and some are PRC investors.
Moreover, the draft law provides that if an offshore transaction results in a foreign investor's acquisition of the control of a domestic enterprise, the transaction is treated as a foreign investment. These rules may frustrate the purpose of many holding structures adopted by foreign investors used to make and exit investments in China.
2. Corporate governance in line with the PRC Company Law
The draft law abrogates the corporate governance rules in the existing FIE laws and regulations. New FIEs would need to comply with the requirements under the PRC Company Law and the PRC Partnership Law, as applicable. Existing FIEs have a three-year transition period to achieve such compliance. However, if the term of an existing FIE expires and is renewed during the three-year period, the FIE must ensure compliance at the time of renewal.
The corporate governance structure set forth in the existing FIE laws differs significantly from that of the PRC Company Law. For example, under the EJV Law, the supreme corporate organization is the board of directors, while under the Company Law it is the shareholder's meeting. The PRC Company Law also requires a company to have "supervisors," while such requirement is not found in the FIE laws and regulations. The joint venture agreements and articles of association of existing EJVs would need to be renegotiated and amended to reflect the corporate governance structure in the Company Law.4
3. National treatment for market entry as a general rule for foreign investment and approval required only for specific industries
The draft law no longer requires that every foreign investment transaction and the related agreements be approved by the National Development and Reform Commission (NDRC) and MOFCOM, or by their respective local counterparts, before the investee entity (such as a joint venture or a wholly foreign-owned enterprise) can be established and registered.5 Under the draft law, the State Council will publish a special catalogue (i.e., the "negative list") comprised of two categories: prohibited industries and restricted industries.6 Foreign investors in industries outside these categories will enjoy equal treatment with local investors, and will only be required to submit information reports to MOFCOM regarding the investments7 rather than to obtain approval from regulatory authorities.
Foreign investments in restricted industries on the negative list will still require prior approval from MOFCOM (and possibly the relevant industry regulators). There are two types of restrictions: investments above a certain monetary threshold set by the State Council, and investments in restricted areas. MOFCOM will review, among other aspects, the impact on national security,8 the satisfaction of conditions imposed in the negative list and the situation of the foreign investor and its actual controller. MOFCOM may either disallow a foreign investment or impose conditions thereon, a decision which may be appealed.
4. National security review
The draft law sets forth the national security review mechanism applicable to all foreign investments, and enumerates a range of factors to be considered in the review, such as impact on national defense, key infrastructures, key technologies, key information and network security. However, there is still a lack of clear guidelines as to what may constitute a threat to national security. The government reserves the right to carry out a review on its own, but foreign investors may proactively apply for national security review, which would afford certainty to the investor in the event of doubt. Relevant government agencies, industry associations, affected enterprises and competitors may also recommend transactions for national security review.
There are two stages to the national security review: general review, which may last 30 business days, and specific review, which may last 60 business days and is an additional period reserved for applications that fail to receive approval during the general review. If the review authority, an inter-ministry committee co-chaired by MOFCOM and the NDRC, believes an investment poses a threat to national security, it should provide a written opinion to the State Council, which shall render a final and non-appealable decision. The review authority may also impose conditions on its approval, the implementation of which will be monitored by MOFCOM.
The draft law provides that MOFCOM and the NDRC will jointly lead the review authority and invite relevant authorities to conduct the national security review. However, it is unclear what other authorities will be involved, who will play a more significant role in the review process, and how the final decision will be made among the relevant authorities.
5. Comprehensive information reporting system
Foreign investors and FIEs are required to file reports of information on themselves and their investments with MOFCOM prior to making the investments or within 30 days thereafter. They are also required to make an updated filing upon certain changes to their basic information or to their investments. If a foreign investor purchases 10 percent or more of the shares of a publicly listed company in China, or enough shares to cause a change of control in the listed company, it must also submit a report to MOFCOM.
Furthermore, foreign investors are required to file annual reports containing basic information on themselves and their investments. If a foreign investment involves the establishment of or any change to a domestic enterprise (FIE), such report shall also include other pertinent information. If the assets or revenues of the FIE are more than RMB10 billion or if it has more than 10 subsidiaries, it is required to file quarterly reports containing its operating and financial information.
The information to be reported is quite extensive, such as the foreign investor's actual controller, the source jurisdiction of investment and the details of operating information. Some of the information requested overlaps with information required to be submitted to the company registration agency, the State Administration of Industry and Commerce and its local counterparts. The draft law also requires foreign investors that control, directly or indirectly, several FIEs provide consolidated annual and quarterly reports, which is likely to create a huge burden on large multinational companies.
In addition, the reported information is open to public search with MOFCOM. Even though the draft law provides that the public search does not apply to trade secrets and confidential information, it is unclear who will decide what constitutes trade secrets and confidential information and how the confidential treatment will be provided. With these uncertainties, foreign investors may be reluctant to disclose sensitive information in the reports. This is particularly a concern for many large multinational companies that are publicly listed abroad and cannot release their business information to the public prior to filing annual or quarterly reports with similar information according to relevant stock exchange rules.
6. Treatment of companies with VIE structures
VIE structures are used by many Chinese companies listed or seeking to list abroad that operate in industries currently restricted to foreign investment, such as telecommunications and online content services. Such structures typically involve a foreign entity setting up an FIE which exercises control over a domestic enterprise via complex contractual arrangements. Such structures have so far largely escaped the scrutiny of Chinese regulators. Under the draft law, such structures would constitute foreign investment if the ultimate controlling owner of the domestic enterprise is determined to be a foreign investor. This may render VIEs ineffective for foreign investors seeking to circumvent the regulations on investing in restricted industries. For the existing VIE structures controlled by foreign investors, the treatment remains unclear and to be clarified in the legislative process.
The draft law would significantly change the regulatory landscape for foreign investors and constitute a milestone in the deregulation of foreign investment. It should facilitate the creation of a clearer framework and a more level playing field for foreign investors in China. Regardless, uncertainties remain with respect to some provisions as well as to more detailed rules. Foreign investors are advised to closely monitor the future lawmaking process in planning and carrying out their investments in China.
1. For example, the EJV Law, CJV Law and WFOE Law each have an implementing regulation. In addition, MOFCOM and other regulatory authorities have issued rules and regulations addressing specific aspects of foreign investments. There is also a special regulation on a foreign investor's acquisition of existing domestic enterprises as opposed to establishing new FIEs.
2. Please see Section 6 below for further discussion of the VIE structures.
3. "Control" is broadly defined and exists with respect to an enterprise if a person holds directly or indirectly 50 percent or more of the equity interests, voting rights or similar interests in the enterprise or, when the holding is less than 50 percent, any of the following is satisfied: (i) the person has the right to appoint, directly or indirectly, or has the power to make sure its nominees will constitute, more than half of the board or other decision-making body; (ii) its voting power is sufficient to influence the decisions of the board, shareholders' meeting or other decision-making bodies; or (iii) the person is able to influence in a "deciding manner" the operations, finances, human resources or technology of a domestic enterprise through contractual or trust arrangements.
4. It is notable that the terms "equity joint venture" and "cooperative joint venture," which have been used since the inception of foreign investments in China, are not found in the draft law. FIEs with foreign and Chinese shareholders or partners would be a normal multiple shareholder company or a partnership under the PRC law.
5. It should be noted that the approval or reporting requirements under the Foreign Investment Law do not replace or otherwise affect the anti-monopoly clearance requirement for an investment transaction.
6. It is not clear what these restricted and prohibited industries are, but guidance can be found in the current "negative list" issued by the Shanghai Free Trade Zone, a test field of the reform policy, in July 2014, which includes 110 restricted industries and 29 prohibited industries.
7. Please see Section 3 below for a description of the information reporting system.
8. Please see Section 5 below for a description of the national security review process.
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