China’s main foreign investment approval body has released a consultation draft of a new uniform foreign investment law for public comment that promises to revolutionise foreign investment in China. Consistent with the trend towards ongoing liberalisation of regulation, China has also expanded the Shanghai Free Trade Zone to include the Lujiazui financial district, the Jinqiao Development Zone and the Zhangjiang Hi-Tech Park. China has also formally announced the creation of additional free trade zones across the country. This alert explains the key details of each of these developments and what they mean for foreign investors.

New Foreign Investment Law Consultation

The draft the Foreign Investment Law (“FIL”) is intended to replace the piecemeal regimes set out under existing laws relating to wholly owned foreign investment, equity joint ventures and cooperative joint ventures (collectively, “Current Laws”). The FIL is a new uniform foreign investment review framework more in alignment with international practices and representing a very significant step in the direction of liberalising foreign investment in the country.

The current foreign investment regulatory system is based on the authorities’ involvement from the cradle to the grave of a foreign invested enterprise (“FIE”). The FIL would replace this three decade old system with a much lighter touch, applying a limited entry clearance and reporting system for investments made in non-sensitive areas.

According to sources close to the drafting process, the PRC Ministry of Commerce (“MOFCOM”) considered the approach adopted under the Australian Foreign Acquisitions and Takeovers Act, the Investment Canada Act and other similar regimes in preparing the draft.

The key changes proposed in the consultation draft FIL are summarised below:

  • More Level Playing Field - Under the new framework, foreign investors will (for the most part) be subject to the same rules as domestic investors for investment establishment unless the proposed investment is in an area prohibited or subject to restrictions under a new “negative list” or has a large total investment meeting certain review thresholds.
  • Information Report to Replace Pre-Approval - Foreign investment projects not covered by the negative list will only be subject to information reporting requirements with reports able to be submitted 30 days after completion. Reports will need to include key details such as total investment amount, relevant industry, geographical scope, shareholding, organisation type and key corporate governance. In an important break from established practice allowing greater flexibility and confidentiality for parties, the JV contract and Articles of Association for such projects would not require approval.
  • New Review Process for Sensitive Investments - For investments covered by the negative list, a new uniform foreign investment review procedure will apply under which the authorities will consider the impact of the proposed investment on national security, energy resources, technology innovation, environmental protection, employment and other public interest matters.
  • Integrated National Security Review - The FIL integrates the national security review framework, elevating it from a policy implemented by departmental regulation to the status of official law. This is expected to reinforce the importance of the national security review process.
  • No Approval for Basic Corporate Dealings - Share transfers, pledges, capital increases and other similar routine matters will no longer require prior authority approval and can simply be reported within 30 days.
  • New Annual Reporting to MOFCOM - All FIEs will be required to submit annual reports to MOFCOM (or quarterly reports in the case of an FIE with significant assets, large revenues or multiple subsidiaries). Although the details of such reports remain unclear, there appears to be some risk of overlap between these reporting requirements and the information currently provided annually to the Administration of Industry and Commerce.
  • Apparent Replacement of M&A Rules - The FIL adopts a broad definition of “investment” with the aim (it would seem) of replacing the special M&A rules which currently apply to foreign-related M&A transactions and, on the whole, create added complication and confusion. While the FIL only explicitly provides that the Current Laws will be repealed, the adoption of a broad definition of investment indicates that Circular 10 and other relevant M&A regulations currently in force will also be replaced.
  • Uniform Corporate Governance Rules - The standard corporate governance rules in the Company Law (and other relevant laws) will apply to FIEs. These standard requirements will replace the special and divergent corporate governance requirements which currently apply and can cause much confusion for investors.
  • New “De Facto Controller” Concept - For the first time, the concept of actual (or “de facto”) control will be introduced to determine whether an enterprise is domestic or foreign. Under this new approach, an entity that is ultimately controlled by a foreign entity or person (including by way of contractual control mechanisms, read “variable interest entities” or “VIEs”) will be regarded as a foreign enterprise even if it is, legally speaking, established as a domestic Chinese company. The inverse position would also apply for foreign companies that are ultimately under Chinese control. The information submitted to the authorities in the new information reporting and clearance system will be required to clearly specify the existence of any “de facto” controller.

Impact on foreign investors

On its face, the de facto controller concept amounts to an official sanction for VIE arrangements under which de facto control is ultimately retained by a Chinese party (such as the original Chinese founder(s)). However, this change could potentially impact foreign investments that rely upon VIE or other “legal grey area” structures. In such cases, foreign investors may need to look for new solutions to restrictions which could involve working more closely with Chinese partners in sensitive areas to manage risks. In this regard, Article 149 (as drafted) provides that foreign investors may be subject to administrative or criminal penalties if they are found to have invested in prohibited or restricted sectors without approval through the use of beneficial or contractual control mechanisms (i.e. VIEs).

The FIL is silent as to the treatment of pre-existing VIE structures. MOFCOM has provided some (very) preliminary comments on how legacy VIE structures could be handled. However, further details are required to meaningfully assess these proposals. This will be a critically important issue for foreign investors already using such structures. Given the wide spread adoption of the VIE across various industries, we anticipate that MOFCOM will approach this issue with caution and the risk of all pre-existing VIE arrangements being declared illegal and unwound is, in our view, relatively low.

The consultation draft FIL is an indicator of the Chinese government’s resolve to promote a market economy, cut red-tape and reduce administrative interference. The terms of the consultation draft are, on the whole, a very positive development which should be welcomed. Subject to the negative list focussing on sensitive issues only (freeing the majority of foreign investments from the burden of over regulation) the new law will provide fresh opportunities, facilitate foreign investment and level the playing field. It will also free up much needed resources of the Chinese regulators to tackle new challenges as China continues to establish its place as an integral part of the global economy.

Comments on the consultation draft may be submitted to MOFCOM (in Chinese language) before 17 February 2015 via this link or by email (to investmentlaw@mofcom.gov.cn).

Shanghai FZT Expanded to Include Key Business Districts

China has expanded the Shanghai FTZ to include the Lujiazui financial district (the part of Pudong in the background of most Bund tourist snapshots), the Jinqiao Development Zone and the Zhangjiang Hi-Tech Park.

Unlike the previous areas covered by the Shanghai FTZ, these zones are all key existing hubs of foreign investment. Accordingly, their inclusion could potentially have very significant implications. Importantly, enterprises established in these areas (pre-existing or otherwise) will be able to take advantage of preferential Shanghai FTZ policies. As Lujiazui is the city’s central financial district and is home to the regional headquarters of many multinational and domestic financial institutions, this move should be seen as a very positive initiative designed to open up new opportunities (particularly in professional services) and further financial liberalisation.

The addition of the new zones to the current areas (being the Waigaoqiao FTZ, Waigaoqiao Free Trade Logistics Park, Yangshan Free Trade Port Area and the Pudong Airport Comprehensive FTZ) will make the Shanghai FTZ the largest in China and a key testing ground for new foreign investment reforms.

Preferential policies applying to the Shanghai FTZ will take effect on 1 March 2015 with a three-year trial period. Under these policies, authorities will roll out a “one-stop-shop” information reporting and record filing system for entity establishments and other dealings (such as mergers and winding up) which will no longer require pre-approval. In this regard, the Shanghai FTZ should be seen as an important testing ground for the proposed reforms spelled out in the consultation draft FIL.

New Free Trade Zones (FTZs)

Three other FTZs have also been announced:

  • Guangdong FTZ which will include the Nansha New Area in Guangzhou, Shenzhen Qianhai and Zhuhai Hengqin New Area;
  • Tianjin FTZ covering Tianjin Port, Tianjin Airport and the Binhai New Area Industrial Park; and
  • Fujian FTZ including certain industrial zones in Fuzhou, the entire cities of Xiamen and Pingtan and a new Industrial Park designed specifically to attract Taiwanese investors.

The new zones will be based largely on the Shanghai FTZ model with each incorporating “local characteristics”. Details on launch dates and detailed implementation rules are yet to be released for the new FTZs.