SAFE Issues New Rules on Outbound Investment by PRC Residents

Article by Barbara W.K. Mok and Ying Li

The PRC State Administration of Foreign Exchange ("SAFE") issued the Circular on Certain Issues of Improving Administration of Foreign Exchange in Connection with Mergers and Acquisitions by Foreign Investors ("Circular") on January 24, 2005. The stated purpose of the Circular is to maintain the balance of international payment and ensure that cross-border capital flows are in compliance with the laws and operate in an orderly manner. In brief, the Circular requires PRC "domestic residents" (undefined) to comply with the approval and registration procedures for (1) overseas investment; and (2) share or asset swap with offshore companies. In the meantime, SAFE’s local branches have been asked to forward to SAFE for processing the application for foreign exchange registration made by a foreign investment enterprise ("FIE") set up by a domestic resident by means of mergers and acquisitions through an offshore vehicle. Further, existing FIEs are subject to strict scrutiny by SAFE’s local branches, which are required to take swift action on any irregularities spotted.

To better understand the Circular, informal telephone inquiries with the officials of SAFE and the Ministry of Commerce ("MOFCOM") were made. In addition, the positions taken by the China Securities Regulatory Commission ("CSRC") and other ministries towards the Circular were discussed with a source close to the CSRC .

It has been widely reported that the Circular was issued primarily in an attempt to curb the rampant dissipation of State-owned assets. This problem has been in existence for years and assumes various forms. A recent trend is for the group of people who are managing or in control of the State-owned enterprise to acquire, through an offshore vehicle, the equity interest or assets and business of the State-owned enterprise at a price substantially lower than the actual business value and then sell the shares in the offshore vehicle to a foreign investor at a much higher price without adding value to the original business.

Against this background, a proposal is said to have been made to MOFCOM, CSRC, SAFE, and other relevant ministries to restrict disguised "overseas investment" made by domestic residents. However, the three government authorities could not reach consensus on the proposal. In the end, SAFE decided to act on its own, resulting in the issuance of the Circular.

The Circular is not entirely self-explanatory and clear-cut, and a number of key terms or phrases remain undefined throughout. Based on our understanding, it may have the following legal implications:

Outbound Investment by Domestic Residents Becomes More Difficult, If Not Impossible. Previously, PRC law has rarely regulated outbound investment by domestic residents (natural persons). The regulations formulated by MOFTEC (predecessor of MOFCOM), MOFCOM, SAFE, and other relevant authorities were primarily aimed at regulating outbound investment made by domestic corporate entities, such as the Measures on Administration of Foreign Exchange for Overseas Investment ("Measures"). By the Circular, SAFE is extending to domestic residents the formalities provided in the Measures that are only applicable to domestic enterprises. To obtain approval from SAFE for conversion of onshore capital into foreign exchange and remittance of the same overseas, the Measures requires the submission of, among others, a letter issued by MOFTEC approving overseas investment. However, MOFTEC and its successor MOFCOM have always declined the function of approving individuals’ overseas investment (up to February 25, 2005, the date we last inquired on this point). Therefore, it is very difficult, if not impossible, for domestic residents to obtain SAFE’s approval to convert onshore capital into foreign exchange and remit it overseas. Unfortunately, this appears to be exactly what SAFE is aiming at. One official of SAFE explained to us: "What the Circular actually means is to suspend all outbound investment until further notice; but when the further notice will come is hard to say."

It remains an interesting, and perhaps tricky, point whether a domestic resident using offshore capital is subject to this provision. Theoretically, if no onshore capital is involved, SAFE would not be relevant. Further, practically speaking, it would be extremely difficult for SAFE to monitor offshore capital flow.

Share Swap Subject to Approval. According to the Circular, the transfer of onshore shares or other property rights by domestic residents in exchange for those of offshore companies is subject to SAFE’s examination and approval. The Circular stops without clarifying the documents or details to be submitted for examination and approval. The officials of SAFE claimed that this article is derived from the last paragraph of Article 9 of Interim Regulations on Mergers and Acquisitions of Onshore Enterprises by Foreign Investors, which were jointly issued by several authorities on March 1, 2003.

Foreign Exchange Registration Halted. As for foreign exchange application made by a new FIE that is set up by a domestic resident by means of merger and acquisition through an offshore vehicle, the local branch of SAFE receiving the application is asked to submit it to SAFE at the national level for approval. In responding to our question as to what that means, the SAFE official stated that such an application would not be approved or it would be difficult, if not impossible, for such an application to be approved. For an existing FIE that has already obtained foreign exchange registration, the SAFE official said that if it is found to have been set up by a domestic resident by means of merger and acquisition through an offshore vehicle, SAFE’s local branches will take action against it. The SAFE official refused to elaborate on what kind of actions would be taken. This newly introduced scrutiny may, in practice, be conducted through the existing mechanism of annual inspection.

If what the SAFE official said is the Circular’s intention, these two measures would have a tremendous adverse impact on the business of an FIE, either newly established or already in existence. It remains doubtful if SAFE will push forward implementation of the Circular, since we believe the number of FIEs affected will not be insignificant and the consequential damage to both FIEs and the Chinese economy will not be trivial.

At face value, the Circular makes it more difficult for domestic residents to conduct overseas investment, thereby creating legal barriers for both overseas listing and cross-border mergers and acquisitions. Upon careful examination, however, the Circular may cause more difficulties to the regulator than to those subject to regulation. To effectively tighten outbound investment, it requires the efforts of more than one regulator, and it will be a mission impossible for SAFE to complete on its own. The absence of endorsement of the Circular by other ministries is also noteworthy. Furthermore, the Circular remains vague as to the specific procedures to be followed by either domestic applicants or local SAFE branches under various scenarios. Perhaps the sole purpose is, just as one SAFE official said, to simply suspend everything for the moment pending the formulation of detailed implementation plans. If this is the case, why was there such hurry in the announcement of the Circular? The implementation of the Circular remains to be tested.

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