On January 19, 2015, the Ministry of Commerce (the “MOFCOM”) of the People’s Republic of China (the “PRC”) released a draft of a newly proposed Foreign Investment Law for public comment (the “New Law”).1 If the New Law is passed by the National People’s Congress and goes into effect, it will entirely replace the current foreign investment legal framework; i.e., the Sino-Foreign Equity Joint Ventures Law of the PRC, the Sino-Foreign Cooperative Joint Ventures Law of the PRC and the Wholly Foreign-Owned Enterprises Law of the PRC (together, the “Current Framework”), and foreign investors in China will need to adapt accordingly.
A. MNCs Will Bear the Brunt of the New Law
Under the Current Framework, most foreign multinational corporations (the “MNCs”) in China operating in the technology, media and telecommunications (“TMT”) industries (areas in which foreign equity ownership is restricted) access these industries free of investment restrictions through a variable interest entity (“VIE”) structure. After review, and discussion with regulators, our assessment of the New Law is that an MNC will be required to disclose2 the Actual Controller of its VIE structure.3 Article 19 of the New Law provides that “actual controller” refers to natural persons or enterprises that directly or indirectly exert ultimate control over a foreign-invested enterprise (“Actual Controller”). If the Actual Controller is not a Chinese citizen or a Chinese corporate entity, then the MNC will be subject to foreign investment restrictions imposed by the New MOFCOM Catalogue (defined below), which is expected to include substantially the same restrictions as MOFCOM’s currently effective 2011 Catalogue.4
Under the New Law an Actual Controller is a person or entity that possesses any one of the following aspects of “control” over the company in question: (1) greater than 50% equity ownership; (2) control of the board of directors or decision-making power over an enterprise; or (3) having decisive impact on the operations of the enterprise (“Control”). As the Actual Controllers of most MNCs are not Chinese citizens or PRC entities, we believe that current MNC’s VIE structures may be challenged by the regulators under the New Law. VIEs controlled by MNCs may require significant corporate restructuring or even divestment in order to comply with the New Law.
B. MOFCOM Officially Recognizes VIEs
The VIE structure has been used for almost two decades and it is commonplace among international investors and companies. However, the VIE structure had always existed in a regulatory “gray” area and was never officially recognized or regulated until, in the official explanation of the New Law that was also issued on January 19, 2015, MOFCOM acknowledged the existence of VIEs operating outside the Current Framework (a step that MOFCOM has never taken before) and expressed its intention to bring them within a regulatory framework pursuant to the New Law.
C. Certain Chinese Founders Will Be Impacted
Many Restricted Industry companies in China are founded and run by Chinese citizens but financed with foreign capital. The use of foreign capital necessitates the use of a VIE structure even though the companies are founded by Chinese citizens; therefore, many VIEs are foreign only because of the source of their financing. Under the New Law, if a Chinese founder wishes to claim that he/she Controls the VIE in question, and thus the VIE should not be subject to foreign investment restrictions, then the founder may need to demonstrate that he/she is a Chinese citizen and that he/she has not taken on a second citizenship (Chinese citizenship is exclusive). If such founder cannot prove that he/she is a Chinese citizen, then the company may be subject to foreign investment restrictions set out in the New MOFCOM Catalogue.
The specific approval procedures and documentation requirements with regard to demonstrating Chinese citizenship will likely not be settled until after the New Law goes into effect. However, we interpret the intent of the relevant provisions to mean that Chinese founders who have acquired foreign citizenship may have risk exposure in this regard.5
D. No Grandfather Clause for Famous Internet VIEs
The New Law will retroactively apply to all foreign-invested entities in China, including those established well before the New Law takes effect.6 Therefore, even internationally recognized Chinese Internet companies that are today listed on foreign stock exchanges and operate in China via VIE structures (e.g. Alibaba, Baidu.com, and Sina.com, etc.) must comply with the New Law. Under Article 45 existing VIEs that wish to be treated as Chinese must submit documentation to MOFCOM to demonstrate Chinese Control.7 Thus, current VIEs, whether publicly or privately held, will be subject to at least a minimal review of Chinese Control.
Further, we interpret the relevant provisions to mean that all VIEs may be given an opportunity to submit documentary evidence to demonstrate that it is Chinese-Controlled and should be identified as having Chinese investors and be permitted to operate in Restricted Industries. The New Law does not set out specific review procedures in this context.
We believe the regulators will have discretion to determine whether an enterprise or an individual is non-Chinese on a case-by-case basis. For example, the regulator might consider residency or tax residency of the Actual Controller or the Actual Controller’s mechanism of control (e.g. super voting stock arrangement). It is also possible that the review of Chinese Control may be stricter in sectors where foreign investment is entirely prohibited, as compared with sectors where foreign investment is limited.
The New Law suggests that any foreign-listed Chinese Internet company that cannot demonstrate to the regulator that it is Chinese-Controlled will be subject to foreign investment restrictions set out in the New MOFCOM Catalogue. Consequences of non-compliance by a company could include an order to cease business, fines, potential revocation of its business license, or a forced re-organization of its ownership structure by MOFCOM.
E. Restricted Industries Remain Unchanged
The New Law stipulates that the relevant authorities will issue a new catalogue of foreign investment prohibitions and restrictions applicable to specific industry sectors (the “New MOFCOM Catalogue”).8 We understand that restrictions on foreign investment in the New MOFCOM Catalogue will not differ substantially from the 2011 Catalogue, which is the current applicable law.
F. Standard Venture Capital and Private Equity Deal Terms Should Remain the Same
Several commentators have noted that the New Law will impact the venture capital and private equity industries in China. We believe that standard venture capital financing terms, such as protective provisions, should remain unaffected because these terms do not affect the level or magnitude of Control by the investor as defined in the New Law. However, the venture capital and private equity industry may be impacted in terms of investment exits. Traditionally, one option for venture capital and private equity funds to exit their China investments was through a trade sale. Potential purchasers in a trade sale would have been a Chinese buyer looking to acquire a competitor or a foreign buyer looking for exposure to the China market. Under the New Law foreign buyers may be excluded as potential purchasers of China companies operating in Restricted Industries.
G. National Security Review Apparatus
Included in the New Law are provisions relating to China’s foreign investment national security review apparatus, which is modeled on the United States’ Committee on Foreign Investment in the United States (“CFIUS”) review.9 These provisions largely formalize the national security review principles that were already in place and in practice.
The New Law is currently only a draft that has been proposed by MOFCOM for public comment. Given that the New Law is still subject to public comment and legislative ratification, there could be changes which could impact our analysis; however, we expect the substantial majority of the New Law to come into effect.
The New Law indicates that a three (3) year grace period will be provided for foreign investors, including “famous” Internet VIEs and MNCs, to come into compliance with the New Law. We believe that Internet VIEs and MNCs that may be impacted by the New Law are well advised to initiate compliance planning before the New Law goes into effect in order to take full advantage of the grace period.