The new law, when implemented, will make sweeping changes to the current regulation of foreign investments.

On January 19, the Ministry of Commerce of the People’s Republic of China published a draft Foreign Investment Law (FIL) that seeks to unify the regulation of foreign investments in China and fundamentally reform China’s regulation of foreign investments. The Ministry of Commerce is collecting public comments on the draft until February 17.

The draft FIL makes a number of sweeping changes to the current regulation of foreign investments. It provides for a consistent set of entry and information reporting requirements and procedures applicable to all forms of foreign investments by foreign investors. Preinvestment approval for foreign investments is no longer required in certain circumstances. The current case-by-case approval system is replaced by a “negative list” approach. The FIL also expands the scope of national security review and establishes specific procedures. What’s more, the FIL is intended to address the regulation of the “variable interest entity” structure (VIE Structure), which is a common structure used by companies funded by private equity or venture capital firms, and many of the companies that use the VIE Structure are currently listed on overseas stock exchanges, including NASDAQ and the Hong Kong Stock Exchange.

Reform of Foreign Investment Legal Framework

The current foreign investment regime recognizes a number of company forms that can be adopted by foreign investors when making an investment in China, such as the wholly foreign-owned enterprise, equity joint venture, and cooperative joint venture. Currently, each of these types of foreign-invested companies is regulated by different laws and regulations and is subject to separate corporate governance requirements that are different from those applicable to domestic companies owned by Chinese investors.

The FIL seeks to provide a consistent set of entry requirements and procedures applicable to all forms of foreign investments and to abolish separate corporate governance requirements for foreign-invested companies. Once the FIL is adopted, the same set of governance requirements will equally apply to both foreign-invested and domestic Chinese companies according to the Company Law. Such unification will largely avoid the confusion of dealing with different practices and regulatory requirements because of the differences between the Company Law and foreign investment laws and regulations.

Broader Definitions of “Foreign Investor” and “Foreign Investment”

The FIL also provides broad definitions of “foreign investor” and “foreign investment” that cover a large scope of activities. “Foreign investor” is not limited to entities registered outside of China and foreign nationals. A company controlled by foreign persons, regardless of its place of incorporation, will be considered a foreign company. Furthermore, “control” can be established under some circumstances even if a party holds less than 50% of the equity ownership. For example, if a person obtains a sufficient voting right that can substantially influence the decision made by another company’s board of directors or is able to substantially influence the operation or finance of another company through contracts or trust, the person will be deemed in “control” of the company. “Foreign investment” is also broadly defined to cover a wide range of activities in a variety of forms, including acquisition of voting rights, provision of long-term financing, ownership in land use rights or any real estate property located in China, control of domestic companies through contract or trust, the right to construct or operate Chinese infrastructures, and concession to explore natural resources in China.

“Negative List” Approach Replacing Case-by-Case Approval System

Under current foreign investment laws and regulations, preinvestment approval by Chinese commercial authorities is required for all foreign investments in China. The articles of association of foreign-invested companies and Sino-foreign joint venture contracts among shareholders (if applicable) will take effect only after they are approved by Chinese authorities.

The FIL simplifies the existing regime by no longer requiring Chinese government approval on a case-by-case basis. Instead, a “negative list” approach, which has been implemented on a pilot basis in Shanghai’s Free Trade Zone, will be adopted. The negative list will set forth specific business sectors restricted or prohibited from foreign investment together with thresholds of investment in certain restricted sectors that will trigger additional government approval. Foreign investors will be required to seek preinvestment approval only if the business is specified as restricted by the negative list. For investments in nonrestricted or nonprohibited sectors, a foreign investor will only need to file an information report within 30 days after completing the investment. In addition, compared with the Foreign Investment Industrial Guidance Catalogue currently adopted in China, the negative list is expected to lift a significant amount of existing restrictions on foreign investments. The negative list, which is not part of the draft for public comments, will be promulgated by the State Council as an auxiliary regulation of the FIL.

When the new approach is adopted, foreign investment projects in China, if not on the negative list, will no longer be subject to pre-investment approval. By doing so, if a business is not on the negative list, foreign investors will be put on equal footing with Chinese investors with respect to regulatory procedures.

National Security Review

Another key piece of regulation that the draft FIL introduces is the national security review mechanism. The draft FIL expands the scope of national security review to “any foreign investment that jeopardizes or may jeopardize national security” without any limitation. The breadth of this review may bring uncertainty to foreign investments because all foreign investments may potentially become a subject of national security review. In the absence of specific guidelines on any threshold or specific trigger for national security review, it is not crystal clear how such review will be initiated in practice. On the other hand, the draft FIL also specifies factors to consider when conducting a national security review, such as the effect that the foreign investment will have on national defense, technology (related to national security), critical infrastructure, communications, energy and food security, public interest, and/or public order.

The draft FIL introduces detailed procedures for national security review. The review needs to be completed in 30 days (which could be extended to 60 days if the facts surrounding the investment are complex). The review can be initiated by either a government authority or the foreign investor. Foreign investors may conduct prefiling negotiation with the government authority before submitting their applications for national security review.

The draft FIL further clarifies that the national security review will be exempt from judicial review. No administrative claim or lawsuit may be raised against the conclusion made by the government committee in charge of the review.

VIE Structure Issue

Under current Chinese law, there are no express provisions that regulate the VIE Structure, a structure originally derived from U.S. Generally Accepted Accounting Principles. VIE Structure, implemented via complicated contractual arrangements among a variety of parties, has been widely used by foreign investors to bypass certain foreign investment restrictions, especially in hi-tech service industries and Internet-related businesses. For years, VIE Structure has not been officially challenged by the Chinese government. But, by expanding the definition of foreign investments to include contractual control by foreign investors, the draft FIL effectively brings VIE Structure to its regulation, and the underlying business under VIE Structure will be exposed to the negative list.

Interestingly, the specific provision related to VIE Structure in the draft FIL is intentionally left blank. Instead, the Ministry of Commerce specified a few proposals to deal with VIE Structure in the explanation letter issued together with the draft FIL. According to the explanation letter, if the VIE Structure is adopted prior to the implementation of the FIL by foreign investors, and if the concerned business is restricted or prohibited under the negative list, the foreign investors may

  • file with the government authority declaring that the concerned business is in fact controlled by Chinese persons, in which case the existing VIE Structure may be preserved;
  • apply to the government authority to confirm that the concerned business is in fact controlled by Chinese persons, in which case the existing VIE Structure may be preserved if confirmation is granted by the government; or
  • submit a foreign investment application to the government authority to officially approve such investment and, in such case, the government authority will make a decision based on the relevant factors, including who actually controls the investment.

It is not clear which of the above alternatives will be eventually adopted or if, when made into law, the FIL will take a different approach. Given the extensive use of VIE Structure in China for many years, any proposal will need to be assessed carefully and thoroughly.