The Ministry of Commerce of the People’s Republic of China recently (19 January 2015) published a first draft of the Law of the People’s Republic of China on Foreign Investments (the Draft Law), for public consultation.1

Overview The Draft Law is a major initiative to overhaul China’s foreign investment policies and would be a significant first step towards establishing a fairer, more transparent and consistent market for both foreign and domestic investments. It consists of 170 articles, and when passed into law it would replace and consolidate numerous laws,2regulations, rules and notices related to foreign investment in China.

Most noteworthy is that the Draft Law marks a shift from the current “case-by-case approval” (the current approval system) to a “national treatment plus negative list” approach to foreign investment projects in China. Under the current approval system, foreign investors must apply for prior approval from the Ministry of Commerce (together with its local counterparts, MOFCOM), which can be delayed or hindered by administrators’ wide discretionary powers. The Draft Law, in contrast, should greatly facilitate investment, except where it falls into an area on the negative list (see below).

The Draft Law also expands the existing national security review of foreign investments by extending the current treatment of mergers and acquisitions to include all foreign investments, which are also now more broadly defined. In addition, the Draft law deals with other basic aspects of foreign investments in China, including investment promotion and protection.

Below are our observations of the key points of the Draft Law.

Overhaul of market access approval and reporting requirements

  • Under the Draft Law, foreign investments in China would be afforded national treatment unless they are in prohibited or restricted sectors listed in the Catalogue of Foreign Investment Subject to Special Regulation Measures (also known as the “negative list”). Foreign investments in sectors outside the negative list, like their Chinese counterparts, would no longer be subject to prior approval by MOFCOM.3
  • The negative list would be issued and amended by the State Council from time to time, reflecting China’s industrial policies on foreign investment as well as its obligations under investment treaties or conventions, such as the China-US Bilateral Investment Treaty and the China-EU Bilateral Investment Treaty that are currently being negotiated.4 The Draft Law prohibits local governments from imposing other restrictions outside the negative list on foreign investments. The Draft Law requires that detailed conditions be set out on foreign investment into restricted sectors which, although still requiring MOFCOM approval5, should make the approval process more transparent than under the current approval system.6
  • In reviewing foreign investments in restricted sectors, MOFCOM should consider the investment’s impact on national security, energy resources, technological innovation, employment, the stage of development of the relevant industry, environment, public interest, and so forth.7 MOFCOM may also seek the opinion of relevant regulatory agencies and stakeholders, and hold public hearings.8 MOFCOM has the authority to approve, reject, or to approve with conditions.9 In the latter two cases, foreign investors will be provided an opportunity to make a case for their investments.10
  • While the Draft Law does not provide details on how MOFCOM should review and approve foreign investments from the above perspectives, it is stated that MOFCOM would no longer examine and approve the articles of association and joint venture contracts for foreign investment projects11. This contrasts with the current approval system, under which the articles of association and joint venture contract for every foreign investment and any subsequent amendments to those documents require MOFCOM review and approval, regardless of whether the investment involved is under the encouraged, prohibited, restricted or permitted sectors. The complete abolishment of this layer of approval should permit foreign investors to negotiate and determine the commercial terms of their PRC joint ventures free from the confines of forms vetted by MOFCOM, a freedom that domestic investors currently enjoy under Chinese law.
  • While abolishing MOFCOM approval for foreign investments outside the negative list, the Draft Law does stipulate general reporting requirements for all types of foreign investments in China.12 There are three types of reporting requirement: (i) initial reporting when the investment is made, (ii) subsequent reporting on changes to the investment, and (iii) ongoing reporting on an annual or more frequent basis.13 The information required by these reports under the Draft Law appears to be even more comprehensive than the information required by current practice and regulation. While after-the-fact reporting requirements can be less onerous than prior MOFCOM approval, foreign investors need to be cautious. Past experience indicates that authorities might seek to apply discretionary powers to delay deemed compliance with the reporting process.

National security review

  • In addition to market access approval requirements, China also undertakes a national security review of any foreign investment that might harm national security, regardless of whether the investment is in sectors on the negative list. Under current law, the review involves foreign investment through mergers and acquisitions. Under the Draft Law, the scope of the national security review would be expanded to all forms of foreign investment, including greenfield, mergers and acquisitions, long-term financing of foreign-invested enterprises, acquisitions of real estate, concessions of natural resources, infrastructure projects, and the acquisition of an interest in and control of Chinese domestic enterprises by contract, trust or other arrangements.14
  • Like many other jurisdictions, “national security” is not defined by the Draft Law. The Draft Law does, however, provide that the national security review should consider the following factors: (i) national defense, including the capacity for products and services demanded by national defense, influence on defense-related key equipment and facilities, as well as the safety of key or sensitive defense installations, (ii) R&D capability in key technologies involving national security, (iii) China’s leading status of technologies involving national security, (iv) the proliferation of dual-use materials and technologies subject to export controls, (v) key infrastructure facilities and technologies, (vi) information and internet security, (vii) the long-term demand for energy, food and other key resources, (viii) the stability of national economy, (ix) the public interest and public order, whether or not the foreign investment is controlled by a foreign government, and (x) other factors that the joint ministerial panel deems appropriate.15 The State Council is authorized to promulgate separate national security regulations for foreign investments in the financial sector.16
  • China’s national security review is procedurally similar to the U.S. CFIUS process. The review body is a joint ministerial panel (the panel) under the State Council and led by the National Development and Reform Commission (NDRC) and MOFCOM.17 The national security review process may be initiated by the foreign investor, the relevant government authorities, trade association, other stakeholders or the panel.18 Foreign investors should considered carefully whether to initiate the review process; if it does not, other interested parties (including commercial competitors) could do so and an adverse ruling could lead to an unraveling of the transaction, with the investor having to bear the cost.
  • A national security review normally consists of two stages: the 30-day initial review, and a further 60-day special review if required.19 If after the special review, the panel concludes that a proposed foreign investment might harm China’s national security, it is required to submit that matter to the State Council for final review.20 National security review decisions are not subject to appeal or judicial review.21
  • The Draft Law allows foreign investors, through negotiation with the panel, to take measures to mitigate any potential harm the investment might cause to national security before a final decision is reached.22 The panel also has the authority to impose conditions on foreign investments in order to eliminate any potential harm to national security.23
  • In cases where foreign investment projects have failed to obtain national security clearance, MOFCOM may order the cessation of the foreign investment, divestiture of the relevant equity interest, and the disposal of the relevant assets or other such measures needed to eliminate potential harm to national security.24 In this case, the foreign investor is responsible for all resultant losses.25

Variable interest entity (VIE) structures

  • The VIE model has been developed to enable foreign investment linked to a Chinese domestic company that operates in sectors in which foreign investments are restricted or prohibited. The VIE structure enables foreign investors to indirectly participate in the sector and enjoy the economic benefits of ownership of the operating entity through contractual arrangements, without actual equity ownership. For the past 15 years, VIE structures have been used by virtually all of the Chinese internet companies that are listed on overseas stock markets to circumvent China’s legal restrictions on foreign investment in the telecommunications sector.
  • The Draft Law would regulate VIE structures by the adoption of “actual control” criteria in determining whether an investment is a foreign investment. In applying the “actual control” criteria, MOFCOM would not merely consider whether the immediate investing vehicle is a foreign or domestic entity, but also look at ultimate control by a foreign investor.26 “Control” under the Draft Law would include the ability to exert decisive influence on the operational, financial, personnel or technological matters of that entity through contract, trust or other means.27 As such, if the “actual control” criteria are adopted in the draft that passes into law, setting up a VIE structure that is actually “controlled” by foreign investors to operate in sectors prohibited or restricted for foreign investments would be illegal for failing to comply with China’s legal prohibition or restrictions on foreign investments. It could be subject to penalties including divestiture and disposal of the relevant interests or assets, confiscation of illegal gains, fines from RMB100,000 to RMB1,000,000, or up to 10% of the amount invested.28 On the other hand, if the VIE structure is ultimately controlled by a Chinese investor, such a structure would be lawful, for the investment would be treated as Chinese domestic investment.29 Assuming the Draft Law is substantially enacted in its current form, it is not clear what approach would be taken regarding existing VIE structures. The Draft Law does not expressly contain “grandfathering” provisions.

While the Draft Law is a step forward to a more open market for foreign investments, many issues need further review and fine-tuning and it is not known if and when the Draft Law, as amended, will become law.