The end of 2011 marks the close of a turbulent and active year for Asia's legal and business community. Throughout, Orrick's Asia in Focus client alerts examined a wide range of legal developments across the region. In this edition of our annual year in review, we highlight two central factors driving new legislation in mainland China that are likely to have continuing impacts for the region in the coming years. The first involves China's ongoing efforts to balance its desire to promote technological innovation with its aspiration to maintain the independence of key domestic industries. The second is the noteworthy progress in Beijing's efforts to internationalize the Renminbi ("RMB").
NPC Adopts 12th Five-year Plan
2011 was significant, not only because it was the 10th anniversary of China's accession to the WTO, but also because it marked the beginning of the country's 12th five-year plan. In March, the National People's Congress adopted the Outline of the 12th Five-year Plan for National Economic and Social Development of the People's Republic of China ("12th Five-year Plan"), which described the primary macroeconomic goals of the central government. The plan will guide the implementation of China's major policy initiatives throughout China through 2015. Briefly, China will continue to restructure its economy, cultivate its strategic emerging industries and promote energy-efficiency and environmental protection.
New Foreign Investment Catalogue Published
The examination and approval of foreign investment projects in China is determined by reference to the Catalogue for Guiding Foreign Investment in Industry ("Catalogue"). The Catalogue is modified and reissued every few years and reflects the central government's broader policies and plans for China's economic development. After circulating a draft in April, a newly revised Catalogue was published in December. The new Catalogue echoes the policies established in the 12th Five-year Plan and encourages foreign direct investment in modern agriculture, high-technology manufacturing, new energy and modern services sectors. In particular, foreign corporations are invited to cooperate with Chinese business regarding various research and development projects. The new Catalogue will take effect on January 30, 2012.
SAFE Relaxes Rules on Round-trip Investments
The State Administration of Foreign Exchange ("SAFE") issued new rules in May that simplified the registration procedures related to "round-trip" investing and fundraising by Chinese residents through offshore special purpose vehicles ("SPV") that in turn hold onshore assets. Circular 19, which took effect on July 1, represents a policy shift away from SAFE's prior restrictions on round-tripping by Chinese nationals and toward SAFE's core mission of regulating cross-border foreign exchange remittance and currency conversion. The new rules permit registration at an early stage of a business, without imposing a time limit on the fundraising activities of the business, and introduce a new category of entity, the "non-SPV," which is eligible for registration. They also no longer require the submission of documents that are not directly related to the ownership and capital structure of the business. Circular 19 also provides for easier rectification of non-compliance with SAFE's prior registration requirements on round-tripping upon payment of an administrative penalty pursuant to a clarified penalty regime.
MOFCOM Permits RMB Cross Border Direct Investment
China has been attempting to gradually internationalize the RMB for several years. In October, MOFCOM took a significant step toward this goal by issuing rules that permit foreign investors to use lawfully obtained offshore RMB to make direct investments in China. The new rules provide added flexibility and assist foreign investors to lower costs and avoid risks associated with currency fluctuation. RMB investment is permitted in any industry other than securities or financial derivatives, subject to the provisions of the Catalogue and China's foreign investment regime. The opening of this new investment channel also may encourage more offshore companies to issue RMB-denominated bonds, or to seek other forms of RMB financing, offshore.
MOFCOM Promulgates National Security Review Procedures
In March, the State Council officially launched China's national security review system and, in September, the Ministry of Commerce ("MOFCOM") issued implementing provisions that formally put in place a national security review procedure. The procedure applies to any acquisition of existing or new equity in, or the assets of, a purely domestic invested enterprise, or existing equity from a Chinese shareholder in a foreign invested enterprise ("FIE"), where the target operates in an industry related to China's national defense. The procedure also applies to such acquisitions if the foreign party obtains "actual control" of a target that operates in other industries that have a bearing on national security such as infrastructure or energy reserves. Foreign investors are prohibited from avoiding the national security review procedure in "any way," including through a nominee shareholding arrangement, lease, loan or variable interest entity ("VIE") structure.
The review procedure is focused on the impact of an acquisition on national defense, national economic stability, social order or the development of key technologies that may affect national security. As the national security review procedure is new, it remains relatively untested, but in situations where MOFCOM determines a potential security risk to exist, it may prohibit the parties from proceeding with an acquisition. In cases where MOFCOM determines a security risk to actually exist, it may unwind an acquisition or take other measures to mitigate any negative impact on national security.
Shanghai Inaugurates Pilot Program for Foreign Invested RMB Funds
Several administrative branches of the Shanghai Municipal People's Government jointly issued rules that permit the establishment of foreign invested private equity funds and fund management enterprises and instituted a pilot program for qualified foreign limited partners ("QFLP"). The new rules took effect in February. To qualify under the pilot program, an applicant must meet certain criteria as determined by a joint council led by the Shanghai financial office and composed of the other main administrative agencies in Shanghai. A qualified pilot fund management enterprise may contribute up to five percent of the total amount of a fund it has promoted in foreign currency without altering the nature of the fund.
The Shanghai rules left some important issues unresolved. First, as the central government has not issued enabling rules for the establishment of an equity investment enterprise ("EIE") with foreign investment, when a foreign invested EIE established in Shanghai attempts to make a portfolio investment in another jurisdiction the other jurisdiction may refuse to acknowledge the legal basis for the acquisition. Moreover, SAFE expressly prohibits an FIE from converting foreign currency into RMB for the purpose of investing in a domestic target, except as otherwise expressly permitted, and the Shanghai rules do not expressly provide a legal basis for conversion. Finally, it is unclear if a fund with a foreign invested manager but solely domestic investors can be treated as a purely domestic fund, which unlike a foreign invested EIE would not be subject to China's foreign investment restrictions or its lengthy approval procedures.
NDRC Mandates Filing Procedures for RMB Funds
In January, in an attempt to provide a measure of national level regulatory supervision on EIEs, the NDRC identified "best practices" and required certain EIEs established in six pilot locations to carry out a filing procedure with the NDRC. In March, the NDRC followed up by issuing a series of guidelines, which set forth various procedures and forms for carrying out the filing procedure and recommended certain content for the key documents that would accompany a filing submission. In November, the NDRC extended the filing requirement beyond the pilot locations to cover EIEs established anywhere in mainland China irrespective of the fund size.
Despite some uncertainty, the rules appear to apply to funds with foreign investment as they expressly require a foreign invested EIE to carry out the standard NDRC project verification and approval procedure, if applicable, when it makes a portfolio investment. Such investments are likely to be subjected to the restrictions and delayed closing requirements imposed on other foreign invested enterprises under China's foreign investment regime. Moreover, the NDRC rules do not expressly permit a foreign invested EIE to convert its foreign currency capital into RMB for the purpose of making equity investments. Hence, unless it has independently generated sufficient RMB cash or it qualifies for quota under a local QFLP program, a foreign invested EIE may not be permitted to fund its portfolio investments at this time.
Various Attacks on VIE Structure
Various permutations of the VIE structure have been used in recent years by foreign internet, e-commerce and new media companies seeking to enter the China market and by the founders of indigenous Chinese internet and media businesses seeking to raise capital outside China. The VIE structure functions by using a foreign entity to establish an FIE and causing the FIE to enter into a series of contracts with a domestic entity and its shareholders. The domestic entity holds the licenses, permits and other qualifications required to lawfully operate in China's restricted sector, and the contracts give the FIE effective control over the ownership and management of, and the right to extract revenue from, the domestic entity.
We witnessed some interesting developments in regard to the VIE structure in 2011. First, Jack Ma, the founder of Alibaba, initiated a debate on the enforceability of the contracts underlying the VIE structure during his dispute with Yahoo! in respect to Alipay, a major subsidiary of Alibaba. The deliberation continued with the promulgation of the national security review procedures discussed above. Finally, the discussion piqued upon unsubstantiated media reports that the CSRC, China's securities regulator, issued a letter to the State Council urging an official crackdown on the VIE structure.