January 23, 2015
On January 19, 2015, the PRC Ministry of Commerce ("MOFCOM") published the draft Foreign Investment Law (the "Draft Law") for public comments, which is intended to replace the existing foreign investment related laws and regulations (the "Existing Laws") and introduce a more market-based regulatory regime for foreign investments into China.
Current Regime
China currently has three major pieces of legislation governing foreign investments: the Sino-Foreign Joint Venture Law passed in 1979 (the "Equity JV Law"), the Foreign Enterprise Law passed in 1986 (the "WFOE Law") and the Sino-Foreign Co-operative Joint Venture Law passed in 1988 (the "Co-operative JV Law"). A particular form of entity is allowed to be set up in China under each of these laws. Under the WFOE Law, for example, a foreign investor can set up a wholly foreign owned enterprise (a "WFOE"). Similarly, under the Equity JV Law and the Co-operative JV Law, foreign investors can set up equity joint ventures or co-operative joint ventures with Chinese partners (the "Joint Ventures"). WFOEs and Joint Ventures are collectively called foreign invested enterprises ("FIEs").
There are two fundamental features of the current regulatory regime. First, foreign investors can only invest in sectors that are not prohibited to foreign investments. China has (and periodically updates) a foreign investment catalogue (the "Investment Catalogue"), which divides foreign investments into three listed categories: encouraged, restricted and prohibited. Those that do not fall under any of these categories are treated as permitted. A potential foreign investor must find out first of all whether and under what restrictions (if any) it can make an investment in a particular sector.
Second, regardless of the form of the FIE (a WFOE or a Joint Venture) and regardless of which category is involved (permitted, encouraged or restricted), the establishment of an FIE must go through a complicated and often lengthy approval process by MOFCOM (including its local counterparts) that also includes a substantive review of the commercial contracts entered into between the relevant parties. For instance, MOFCOM often requires parties involved in a Joint Venture to change the commercial terms already agreed between them if such terms in its view are prejudicial to the Chinese party’s interests. By contrast, there is no requirement to go through a similar approval process for setting up a non-FIE (a "Domestic Entity"). In other words, there is a lack of national treatment for FIEs in China, which the Draft Law proposes to narrow without abandoning entirely.
Proposed Changes
The major changes proposed in the Draft Law include the following:
- Special Administrative Measures Catalogue
The Draft Law proposes to use a special administrative measures catalogue (the "Special Measures Catalogue") to replace the existing Investment Catalogue. Unlike the Investment Catalogue, there are only two categories under the Special Measures Catalogue: the prohibited and the restricted. If an industry (such as media and weapons) is prohibited to foreign investment, there will be no need for any approval as such investment is simply not allowed. If a project falls under the restricted category either because it is in a particular industry or because it involves an investment in excess of a certain threshold amount, an entry permit (the "Entry Permit") must be obtained.
On the other hand, if an industry is not listed in either the restricted or the prohibited category, foreign investors will not need to obtain an Entry Permit under the Draft Law; they will be able to set up entities in China like domestic investors. As many of the FIEs are in the non-prohibited and non-restricted categories, this would represent a significant liberalization of China’s foreign investment regulatory regime.
- Application for Entry Permit
Depending on the amount of investment involved (which is determined by the PRC central government), an Entry Permit can be obtained from the central government or a local government. While the current regime also differentiates those investments requiring central government approvals from those requiring local government approvals only, one key difference proposed under the Draft Law is that no commercial contracts (such as the joint venture contract for a Joint Venture) are required to be submitted for approval. The approval process, therefore, is expected to be shorter and simpler.
- Special FIE Requirements
Under the Existing Laws, FIEs must comply with certain requirements that are not applicable to the Domestic Entities. For instance, certain decisions of a Joint Venture (such as an increase in the registered capital) must be approved unanimously by all the directors of the Joint Venture. There are also strict requirements relating to the debt/equity ratio of an FIE. These requirements are expected to be dropped after the adoption of the Draft Law because the FIEs will be required to be incorporated under the PRC Company Law instead of the Existing Laws that only apply to FIEs.
- National Security Review
China already has a set of administrative rules relating to the review of foreign investments based on national security concerns (similar to the CFIUS review in the United States). The Draft Law has provided additional details and procedures relating to the review process, including pre-submission consultations, conditional approvals and post-review monitoring. Significantly, the Draft Law expressly states that national security review decisions will not be subject to administrative or judicial review.
- Nature of Foreign Investment
Under the Existing Laws, an FIE is defined as a PRC entity whose direct or indirect shareholders include a non-PRC person or entity. This characterization is rather formalistic because a PRC company can be treated as an FIE even if it is 100% owned by a PRC national so long as there is an offshore entity in the ownership chain. Under the Draft Law, in applying for an Entry Permit, a foreign investor can also apply for its investment to be treated as domestic investment if it can be proven that such foreign investor is ultimately controlled by PRC nationals.
On the other hand, if a foreign entity obtains control over a Domestic Entity through contractual arrangements, such foreign entity shall be deemed to have made an investment in China even though it does not own any interest in such Domestic Entity and such Domestic Entity shall be treated as an FIE (the "Control Rule").
- VIE Structure
The structure involving a variable interest entity owned by PRC nationals (a "VIE") refers to a structure whereby an FIE obtains control over and receives most of the economic benefits from a VIE not through acquisition of its equity but through a series of contractual arrangements. Specifically, the PRC owner of a VIE can set up an offshore company (often together with foreign investors) which in turn can set up a WFOE in China. The WFOE can then enter into a service agreement and other arrangements with the VIE whereby most of the revenues of the VIE will be paid over to the WFOE as service fee. This structure is used in cases where the actual acquisition of the VIE by the WFOE is not allowed or where the engagement by the WFOE in the relevant business is subject to approval that is difficult or impossible to obtain. Put another way, this structure allows foreign investors to enjoy the economic benefits of the VIE even though they do not actually own it.
The VIE structure is very popular in China and many leading Chinese internet companies with this structure are listed on the NASDAQ or NYSE (including Alibaba). MOFCOM apparently is aware of the potential inconsistencies between the VIE structure and the Control Rule. In an explanatory note of the Draft Law, MOFCOM pointed out first of all that control by a foreign entity of a Domestic Entity through contractual arrangements will cause such Domestic Entity to be treated as an FIE under the Draft Law. In other words, a VIE will be treated as an FIE even though it is owned by a PRC national. Second, with respect to the existing VIE structures, MOFCOM acknowledged that there is wide-spread concern over the legality of those structures and stated that it will propose solutions after receiving comments from the public during the consultation period. In particular, MOFCOM noted that three solutions have been suggested by scholars and market practitioners:
i) a foreign entity can continue to operate a VIE structure after reporting the VIE arrangements to the government;
(ii) a foreign entity can continue to operate a VIE structure after proving to, and obtaining certification from, the government that it is ultimately controlled by a PRC national; and
(iii) a foreign entity can continue to operate a VIE structure only after obtaining an Entry Permit.
Unanswered Questions
While definitely an improvement over the Existing Laws, the Draft Law also leaves certain important questions unanswered. One of them, as discussed above, is whether the existing VIE structures will be grandfathered after the adoption of the Draft Law.
In addition, to what extent the Draft Law would improve the Existing Laws will depend on what will be included in the prohibited and restricted categories under the Special Measures Catalogue, which has yet to be published. Many investors are hoping that the lists will differ significantly from those under the Investment Catalogue.
Furthermore, it is not entirely clear whether the existing rules relating to acquisition of Domestic Entities by foreign investors will be replaced by the Draft Law (though they may be). In particular, the Draft Law has not addressed the issue of "roundtrip investment", which refers to an acquisition by a foreign company controlled by a PRC national of a Domestic Entity. Under rules issued by MOFCOM in 2006, all such investments must be approved by the central government regardless of the size of the investment. MOFCOM apparently has never issued any such approval, which, among other things, has forced people to use VIE structures in cases where there is no other regulatory reason to do so.
Finally, there is limited history of national security review in China. Foreign investors need to wait and see how the review will be implemented in practice under the Draft Law.
The Existing Laws were very much a product of China’s old planned economy. Still, China has managed to be the top destination for foreign investments among the emerging markets in the last three decades. The Draft Law, if adopted, is expected to further promote foreign investments into China.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have about this development. Please contact the Gibson Dunn lawyer with whom you usually work or the following:
Yi Zhang – Hong Kong (+852 2214 3988, [email protected])
Fang Xue – Beijing (+86 10 6502 8687, [email protected])
Joseph M. Barbeau – Beijing, Hong Kong, Palo Alto ([email protected])
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