On 19 January 2015, the Ministry of Commerce of the PRC (“MOFCOM”) published a discussion draft of the proposed new Foreign Investment Law (“Draft FIL”) on its official website for public comments. As part of a trend of transforming the role of government in the economy and simplifying red tape, this new legislation will revamp how China interacts with foreign investment which has been long-awaited.

China is not the same country when the Sino-foreign Equity Joint Venture Enterprise Law was promulgated in 1979. In addition to its rapid growth and developing economy, there has been in recent years strong and sustained growth in outbound investments by Chinese enterprises. This has led to China changing from a net capital inflow country to a net capital outflow country in 2014. No doubt China’s perspectives and strategies on both inbound and outbound investment regime have reshaped dramatically reflecting the changing economic landscape.

The Draft FIL, once enacted, will eventually replace the trio of the Sino-foreign Equity Joint Venture Enterprise Law, the Sino-foreign Cooperative Joint Venture Enterprise Law and the Wholly Foreign-invested Enterprise Law as well as its implementation rules and ancillary regulations (collectively, “Three FIE Laws”), and will have a long-lasting impact upon foreign investment by significantly reshaping the entire Chinese foreign investment regulatory regime. This essay aims to combine our experience in the areas of foreign direct investment and M&A with our analysis and comments on the legislative background, features and major reforms contained in the Draft FIL.

Legislative Background of the Draft FIL

Since the introduction of the Three FIE Laws at the start of China’s reform and opening up, for three decades they have played a foundamental role in regulating how China interacts with the inflow of foreign capital, foreign advanced technology and management expertise. However, in the wake of economic development and social changes, the Three FIE Laws face numerous impediments and issues:

1. Excessive Regulation of Foreign-Invested Enterprises

Under the current foreign investment regulatory regime, a foreign-invested enterprise, regardless of its scale, investment amount and industry, will require governmental approval from cradle to crave, including its incorporation, liquidation, increase or decrease of capital or share transfer. Such an extensive approval system played a positive role in guiding and regulating foreign investment in an earlier time but in today’s much bigger economy the requirements that seemed reasonable (indeed seemed bold) 30 years ago are now excessive and even interfere with commercial activities and market competition at times. The regulatory red-tape increases regulatory costs for foreign investors and, to some extent, impedes free competition and liquidity flow.

2. Conflicts with the Company Law, the Securities Law, the Partnership Law and the Individual Proprietor Enterprise Law

Although the amendment to the Company Law in 2005, specifically stipulated in principle that ‘this Company Law shall apply to all foreign-invested limited liability companies and joint stock companies’, an exception was also made – “where foreign investment laws have conflicting provisions, such provisions shall prevail”. This stipulation has led to many controversies in practice as to how to deal with areas of potential conflict between the Company Law and the Three FIE Laws. For example, the corporate governance structure of a sino-foreign equity joint venture enterprise is generally regulated under the Sino-foreign Equity Joint Venture Enterprise Law, but in practice the Company Law will also apply to a certain extent to the corporate governance of such enterprise. Investors are often confused by attempting to reconcile conflicting legal requirements.

In addition, the rules on foreign-invested joint stock companies and partnerships are scattered across various departmental regulations. It is even more difficult in practice to resolve conflicts between these rules and the Company Law, the Securities Law and the Partnership Law.

3. Inconsistencies among Ancillary Foreign Investment Regulations

With the diversification of foreign investments in China, the development of anti-monopoly legislation and the rising concern of national economic security, the Chinese foreign investment regulatory regime has been evolving continuously with the promulgation of a series of state and departmental regulations. Examples include the well-known Circular 10 (Regulations on the Takeover by Foreign Investors of Domestic Enterprises), the various notices and announcements on the establishment of national security review mechanism, the Regulations regarding the Transfer of Shares in Foreign-invested Enterprises (applicable to the acquisition of foreign-invested enterprises), the Interim Regulations on Domestic Investments by Foreign-invested Enterprises (applicable to domestic investments by foreign-invested enterprises), the Regulatory Measures on Foreign Investors’ Strategic Investment in Listed Companies (applicable to the acquisition of listed companies by foreign investors), etc. These regulations have played an important role for the establishment of a sound legal system on foreign investment, but the main issue was the fact that they were released at different times to address different concerns, leading to a lack of coordination and even conflicts between the different regulations.

Features of the Draft FIL

The Draft FIL contains 11 chapters and 170 articles, and covers: (1) definitions of foreign investors and foreign investments; (2) administration of foreign investments which are subject to entry clearance (3) national security review; (4) comprehensive foreign investment information reporting system; (5) promoting investment, protecting investment and coordinating complaints; (6) legal liabilities and (7) miscellaneous provisions. Compared to the more abstract provisions in the Three FIE Laws, the Draft FIL is more extensive and specific as to how foreign capital will be admitted and administered within China. The Draft FIL has the following distinct features:

1. Radical Changes to the Existing Foreign Investment Regulatory Regime

The Draft FIL completely abandoned the existing comprehensive approval system, and adopted instead a limited foreign investment entry clearance system for selected industries and an information reporting system that is more in alignment with international practices.

The Three FIE Laws which are currently in force contain special provisions on the corporate governance structure of foreign-invested enterprises, which leads to discrepancies in the corporate governance structures between domestic enterprises and foreign-invested enterprises. The Draft FIL is silent on the corporate governance of foreign-invested enterprises, and does not distinguish between the corporate forms (e.g. JV or WFOE, limited liability company or stock limited compnay) they may take. After the implementation of the Draft FIL, foreign-invested enterprises will have the same corporate governance structure as domestic enterprises by applying the Company Law, the Securities Law, the Partnership Law, etc.

The Draft FIL does not limit the definition of “investment” to greenfield investments or establishment of legal entities, but extends the definition to include mergers and acquisitions, real property transactions, financing for more than one year, concessions for the exploration and development of natural resources, concessions for the construction and operation of infrastructures, contractual / fiduciary control and other investment methods (but it seems that asset acquisition is leaked in the Draft FIL). Through a broad definition of investment, the Draft FIL will be able to replace the prevailing M&A regulations applicable to a variety of M&A transactions, and at the same time comprehensively regulate foreign investment in various forms, regardless of whether it involves commercial presence in China or not. While the draft explicitly provides that the Three FIE Laws will be terminated upon its inception, it is likely that related regulations such as Circular 10 and other relevant M&A regulations will also be repealed simultaneously.

2. Reference to other International Foreign Investment Regimes

The Draft FIL has been prepared with reference to the Investment Canada Act, the Foreign Acquisitions and Takeovers Act 1975 (Australia) and other legislative precedents from some other Western countries. For example, the definition of foreign investor seems to reference the Australian precedent, which identifies foreign investors based on “control”, i.e. enterprises (whether based onshore or offshore) under the control of foreign investors will also be treated as foreign investors. It is worth noting that a foreign investment regulatory system based on the concept of control will likely cause the Foreign Investment Law to have extraterritorial effect. Article 15 of the Draft FIL specifies that, if an offshore transaction causes the transfer of de facto control over an onshore enterprise to a foreign investor, such foreign investor will be deemed as investing onshore. In addition, a number of provisions in relation to information reporting had referenced the Investment Canada Act, and the foreign investment special administrative catalogue (i.e. the ‘negative list’), is also based on an internationally accepted entry clearance mechanism.

3. Adherence to Substance Over Form Principle

The Draft FIL, in many aspects, adheres to the principle that substance of a foreign investment project will take precedence over its form. For example, when identifying the foreign investors, the Draft FIL adopts the concept of de facto control and takes into account whether the de facto controller of an enterprise is foreign or Chinese, rather than simply its place of incorporation.

Furthermore, Article 149 specifies that any investment in either prohibited industries or in restricted industries without entry clearance using a means of circumvention such as shadow shareholding, trust, contractual control (or VIE) and offshore transactions, will subject the investor or foreign-invested enterprises to administrative or even criminal penalties. Consequently, some foreign investment practices that are considered to be in the gray area may be reassessed under the Draft FIL by looking to their substance rather than merely the form.

In addition, when deciding whether a foreign investment should be subject to entry clearance based on the investment amount (Article 26, 27, 28 and 29), the “cumulative investment amount by a foreign investor on the same project within a 2-year period” and “the financing provided by a foreign investor directly or indirectly for more than 1 year” should be aggregated and counted in. In comparison, under the current foreign investment regime, when deciding the level of the approval authority for a foreign investment project, it typically only takes into account a single total investment amount; in reality, in order to circumvent higher-level government approvals, some projects will break up the total investment amount into several tranches of capital injection. In comparison, the future Foreign Investment Law will likely implement more rational supervision over large-amount investment projects by preventing division of such projects.

Major Institutional Changes under the Draft FIL

The following paragraphs summarise the major changes introduced by the Draft FIL and their potential impact on the foreign investment activities:

1. Limited Entry Clearance Replacing Foreign Investment Approvals

The Draft FIL specifies that foreign investments will receive national treatment, except for ones that fall under the special administrative measure catalogue (i.e. the “negative list”). The negative list will only comprise of two categories: the prohibited industries and the restricted industries; foreign investment in industries not listed in the negative list will not be required to apply for entry clearance or make record filing and will only be required to submit information reports.

The negative list is very different from the current Industry Catalogue for the Guidance of Foreign Investments (“Investment Catalogue”), which is the key document complementary to the prevailing foreign investment approval regime. The Investment Catalogue specifies the encouraged, restricted and prohibited industries for foreign investment, and the industries not specified are treated as permitted industries. Nonetheless, in effect foreign investment in each category requires MOFCOM approval.

In the future, when the Foreign Investment Law comes into effect, a negative list will be needed to replace the Investment Catalogue. The negative list is a entry clearance approach adopted by many developed countries and has been widely accepted by global investors. According to MOFCOM statistics, currently more than 70 countries have adopted a negative list approach. The shift from comprehensive approval regime on foreign investment to a negative list approach is a major legislative and regulatory improvement for China. During the recent Sino-US, Sino-EU and Sino-Australian bilateral trade talks, the further opening up of foreign investment industries, deregulating of foreign investment regime and shortening of the negative list have always been key negotiation topics.

Since 2013, Shanghai Free Trade Zone has adopted the negative list regime on a pilot basis, which replaced the Investment Catalogue within the free trade zone. It also innovatively replaced the approval requirement for foreign investment outside the negative list with record filing. However, there is wide concern with whether a record filing procedure is really an approval in disguise. Especially, in the Approval and Filing Administration Measures on Foreign Investment Projects implemented by NDRC on 17 June 2014, most of the foreign investment projects previously subject to approvals were changed to record filing, but NDRC actually has the authority to not allow record filing depending on the factual circumstances. The Draft FIL has overcome the often controversial and vague record filing procedure, and revolutionarily introduced the information reporting regime – all foreign investment projects not within the negative list will only be required to submit information reports to the competent foreign investment authority through a dedicated reporting system, and no governmental review is required (see Section 2 below for further details).

The main focus of the entry clearance regime is to consider the impact of the foreign investment on national security, energy resources, technology innovation, environmental protection, employment and other matters of public interests, as well as the identity of the foreign investor and de facto controller. The entry clearance review will not take into account the internal governance structure and decision-making procedures of the foreign-invested enterprise. Futhermore, the transaction documents (e.g. joint venture contract, share purchase agreement) are no longer explicitly listed as required documents for submission. Article 30 of the Draft FIL merely requires that the application report to include information such as investment amount, industry, investment method and geographic area, shareholding ratio, capital contribution method, the organization type and corporate governance structure of the foreign-invested enterprise. Under the existing legal framework, considering that the joint venture contract, articles of association or share purchase agreement will only become effective upon the government approval, the transacting parties can only propose their commercial arrangement within certain limits. When any intended arrangement deviates from the law, the only recourse is to consult with the approval authorities. The changes brought forth by the entry clearance regime may mean that in the future, the parties will enjoy more freedom in opting for terms and condition to meet their commercial needs. Conceivably, this will create more room for innovative commercial arrangements and more possibilities for foreign participations in the Chinese capital markets.

At the same time, we also notice that although Article 32 of the Draft FIL includes a list of factors to be considered during the entry clearance review process, the factors are very general and do not specify any criteria on how to evaluate each factor, such as employment, capital project administration and the foreign investor and de facto controller. As such, it is is challenging for a foreign investor to know exactly what the specific criteria are and to modify commercial arrangements beforehand. Without any additional details, the entry clearance review procedure will likely be rather vague to bring uncertainty to actual operations.

In addition, Article 33 of the Draft FIL further elaborates on the relationship between entry clearance and industrial admission. Where industrial admission is required before issuance of business license, the competent foreign investment authority should state in its review decision the status of the industrial clearance. Where industrial clearance is only required after issuance of business license, the competent foreign investment authority should consult with the competent industrial authority during its review. Nevertheless, if industrial clearance is required, it is unclear how the foreign investment authority and the industrial authority will coordinate and reconcile their respective review criteria, and whether the difference in their criteria will bring greater uncertainty to the whole review process.

2. Comprehensive Information Reporting System for Foreign Investment

As mentioned above, the information reporting system is disparate from the approval or record filing system, but more similar to ex-post reporting after completion of investment. However, the penalty for contravention under the reporting system is severe. Any company found to be non-compliant with its information reporting obligations or concealing truth, providing misleading or false information will not only be subject to monetary fines arising from administrative or criminal liabilities, the persons directly responsible may also be criminally liable (Article 147 and 148).

The Information reporting system includes the investment implementation report, the investment amendment report, the annual report and the quarterly report. It is worth noting:

Investment implementation report may be submitted before or within thirty days after the completion of an investment. However, we understand, if a foreign investor submits the report before the commencement of an investment, there is a risk that such report will need to be amended or withdrawn at a later date due to possible adjustment in the investment structure, termination or abandonment of the investment. Hence, it may be more efficient if all reports are submitted after the completion of the investment. Share transfer, pledge, capital increase and other matters that used to require prior approvals, can now be reported within thirty days after the completion of such event. Quarterly report only applies to large foreign invested enterprises controlled by foreign investors, namely, those enterprises with total assets, sales or revenues over RMB 10 billion or have more than 10 subsidiaries in China.

Although comparing with the current approval system, the information reporting system significantly eases the regulatory scrutiny over foreign investments, we also note that the scope of the information reporting is very extensive. In comparison with the information reporting system of other developed countries (such as Canada), the reporting obligations under the Draft FIL are significantly more cumbersome. With respect to the reporting frequency, in addition to the investment implementation report and the investment amendment report, an annual report is mandatory, and large foreign investors are requested to report on a quarterly basis. Since the goal of the current legislation is to further deregulate foreign investment, it is worthwhile to consider reducing the scope of the reporting requirements.

In particular, some of the information requested may be sensitive to foreign investors, such as the identity of the actual controller and the source of investment. This information is not required under the current approval regime. In practice, due to various considerations such as tax, strategic reasons, the foreign investor may choose to adopt complex offshore structures, thus it may be difficult to ascertain the actual controller. The requirement to disclose sensitive information may even dissuade potential foreign investors from coming into China. If the main reason for ascertaining the identity of the actual controller is to find out whether a company is ultimately controlled by a Chinese entity, then this requirement may be revised to require only the confirmation on whether the actual controller is a Chinese entity or national.

In addition, there is an overlap in the information reporting requirement and the information required by the Administration for Industry and Commerce (i.e. the compay registry administration in China) such as the basic identity information of the foreign investor and foreign-invested enterprise. If, in the future, the foreign investors are required to submit the same information to two different systems, not only will the administrative burden on the foreign investor be increased, the public may also have to verify the same information maintained under two different systems.

3. National Security Review

Since 2011, the national security review related rules and regulations have been promulgated by the State Council or by way of announcements issued by MOFCOM. However, under the Draft FIL for the first time the national security review will be incorporated as a separate chapter in the Foreign Investment Law (Chapter Four). This elevates the national security review from departmental regulations to official law. In addition to following the existing joint ministerial mechanism to carry out security reviews on foreign investment and the general and special review procedures, the national security in the Draft FIL has the following distinct characteristics:

The scope of national security review seems to be expanded. According to the current national security review provisions, the national security reviews are limited to foreign investment in certain domestic industries relating to national defense security, and foregin investment in other national security areas which may have an impact on national security and where foreign investors may acquire de facto control of such enterprises. Although the list of targeted industries was never published, rumors are that the national security review is applicable to 57 industries. However, under Article 48 of the Draft FIL, national security review will likely apply to “any foreign investment that harms or likely endanger the national security” and is not limited to acquision of controlling stake of domestic enterprises or to any particular industry. The expansion of the scope of national security review and the lack of applicable standards may cause concerns from the foreign investors that any foreign investment project may be subject to national security review, which may potentially lead to issues such as lack of regulatory transparencies and certainties. The national security review and entry clearance are better inter-connected under the Draft FIL and at the same time more specific in application. If any relevant foreign investment department has concerns as to a potential national security related issue during the entry clearance process, then it will suspend the review and transfer the case to the joint ministerial panel to conduct national security review. The foreign investor may, before proactively applying for the review, make appointment to discuss any procedural issues. In addition, the joint ministerial panel may at its own initiative launch national security review and may conduct the national security review again if an enterprise conceals information, provides misleading representation during the review process or violates any condition stipulated in the security review clearance. As the national security review is now embedded in the Draft FIL and thus has its level of legal effect escalated, the national security review has a judicial immunity clause to the effect that the decisions of the review cannot be appealed or subject to administrative review.

4. Actual controller and potential impact on VIE Structure

The Draft FIL introduces for the first time the concept of actual controller from the foreign investment perspective, i.e. whether a company is considered as a foreign invested or domestic company is not solely based on the place of registration but focusing on “actual control”. According to the definition of “Chinese Investor”, Chinese nationals and the companies under their control will be classified as Chinese Investors. At the same time, the definition of “control” also references from internationally accepted definition, including control of shares, voting rights or other equity interests of a company, control of the decision-making bodies of the company, or possession of decisive power to influence the management, finance, personnel or technology of the company through contractual, trust or other arrangements. According to the above definitions, the legal validity and the associated risks of variable interest entities (VIE) structure may need to be reassessed.

VIE is not only a common structure adopted by many Chinese companies listed overseas, it is also sometimes used by foreign investors to invest or operate in areas subject to foreign investment restrictions. The legality of VIE structures and funds transfer under the VIE structure have been the focus of foreign investors for a long time. All major overseas capital market regulators are also assessing the legal and regulatory risks under the structure. According to the Draft FIL, under the VIE structure, if the actual controller is of Chinese nationality, then the relevant domestic company shall be treated as a Chinese investor and, therefore, the entry clearance and the information reporting systems applicable to foreign invested enterprises will not apply. Accordingly, under this situation, the VIE structure may be considered as legitimate. Conversely, if the actual controller is a foreign entity or national, then the domestic companies will be treated as foreign-invested companies, and any operation without entry clearance may be considered as illegal.

However, for companies that are successfully listed overseas or companies controlled by foreign investors with operations in China using VIE structures prior to the promulgation of the Foreign Investment Law, the Draft FIL does not provide a clear answer as to how they will be perceived if domestic companies fall into the Negative List and such decision is likely to be influenced by the feedback received from the comments solication process. Based on our speculation, because of the influential power of many companies using VIE structures in various industries, the risks that the existing VIE structure is considered as illegal after the promulgation of Foreign Investment Law are relatively low. In the future, the regulators will likely take a very cautious approach and make decisions on a case-by-case basis depending on the actual situation.

5. Other issues related to the Draft FIL

Some of the other issues covered in the Draft FIL worthy of consideration include:

Transition from the current regulatory regime to the new regime. The Draft FIL sets out basic principles on how to deal with issues which may arise during the transition period. Foreign invested enterprises are provided a 3-year transition period to change its legal form and governance structures so as to align with the Company Law, the Partnership Law and the Individual Proprietor Enterprise Law. Before completion of such change, the Three FIE Laws remain in place. However, it appears that the Draft FIL does not contain much guidance on other investment forms during the transition period. Some examples, how should long-term financing and the real estate transactions that fall within the scope of Foreign Investment Law be treated during the transition period? Or, after the promulgation of the Foreign Investment Law, how should M&A transactions carried out in accordance with Circular 10 be treated? Connection with the foreign exchange system. Currently, foreign exchange control under capital accounts has not been fully deregulated. The current foreign exchange system mirrors the current foreign investment approval system. In practice, the foreign exchange administrative department reviews the remittance, settlement and use of capital under the capital accounts in accordance with decisions made by MOFCOM regarding the establishment, capital increase, share transfer and the liquidation of foreign investment projects. Therefore, the revamp of the foreign investment regime will inevitably be a great challenge to the current foreign exchange system. For instance, with respect to foreign investment projects not subject to entry clearance, whether the control of foreign exchange funds under relatded capital accounts would also be eased and deregulated; furthermore, according to Article 11, domestic enterprises controlled by foreign investors will be treated as foreign investors, which means that any investment made by such foreign-invested enterprises in China will be treated as foreign investment. However, currently only the foreign-invested holding companies are regarded as foreign investors with the advantage that they can use the foreign capital settlement to make domestic equity investment. If the foreign controlled domestic enterprises are also considered as foreign investors, will they also be allowed to use the foreign capital settlement for domestic equity investment in the same way as the foreign-invested holding companies?

The Foreign Investment Law, if promulgated in its current draft form, will fundamentally change the current foreign investment regulatory landscape. As such its implementation will rely on the formulation of relevant implementation rules as well as other complementary guidance, such as the Negative List, the national security review guidance and information reporting rules. While the circulation of the Draft FIL is an important first step in the context of the landmark reform, there is still a very long way to go in the establishment of a new foreign investment regime and the full implementation of the Foreign Investment Law. According to the Legislative Work Plan for the State Council in 2014, the amendment of the Three FIE Laws falls within the ‘research projects’ of 2014. MOFCOM, as the department responsible for drafting the Foreign Investment Law, has started to circulate the Draft FIL for public comments at the very start of 2015. This demonstrates the determination of the Chinese government to carry out reform. Upon expiration of the period soliciting public comments (approximately 1 month), MOFCOM will revise the Draft FIL on the basis of comments gathered from the public, and submit the revised draft to the standing meeting of the State Council for deliberation and then circulate an updated draft for the Standing Committee of the National People’s Congress to review. With the objective of establishing a “new open economy system” and along with the negotiation of Sino-US and Sino-EU bilateral investment agreements, we belive we are now at the dawn of the era of the new Foreign Investment Law.