Having solicited public comments since December 2013 on China’s three primary foreign investment laws, i.e., the Law on Wholly Foreign-Owned Enterprises, the Law on Sino-Foreign Equity Joint Ventures and the Law on Sino-Foreign Contractual Joint Ventures (collectively, the “Existing Foreign Investment Laws”), the Ministry of Commerce (“MOFCOM”), on January 19, 2015, published a draft version of the Foreign Investment Law (外国投资法) for public comment; on the same day, MOFCOM issued an explanatory note (说 明) (the “Explanatory Note”) on the draft law. If passed, this law will represent a major step in China’s efforts to rationalize its foreign investment regulatory regime in line with prevailing international best practices. The firm submitted comments on the Existing Foreign Investment Laws in January 2014 through AmCham Shanghai and is planning to submit our comments on the draft Foreign Investment Law shortly. Some of the highlights of this draft law include:
(1) Migration from the Existing Foreign Investment Laws to the Foreign Investment Law. The Existing Foreign Investment Laws (and all their implementing regulations) will be superseded by the Foreign Investment Law. Many commentators have noted various major deficiencies of the Existing Foreign Investment Laws in terms of, inter alia, national treatment of foreign investors, corporate governance, efficiency of the approval and regulatory regime and consistency with China’s domestic corporate law. While it would be a welcome development to migrate from the Existing Foreign Investment Laws to a unified Foreign Investment Law, international investors will be on the lookout for commercially sensible and transparently applied policies to deal with any transition issues related to the vast number of foreign-invested businesses already established or are in operation under the Existing Foreign Investment Laws. (2) Unified Corporate Law for Both FIEs and Chinese Businesses. Unlike the Existing Foreign Investment Laws, the draft Foreign Investment Law refrains from regulating the corporate form of foreign-invested enterprises (“FIEs”). This suggests that FIEs, like Chinese domestic enterprises, will be subject to a generic body of Chinese corporate law, as currently embodied in such laws as the Company Law, the Partnership Law and the Individual Wholly-owned Enterprise Law, in terms of incorporation, corporate governance, liquidation and other corporate matters. We expect that these laws will be revamped also in due course in light of China’s financial and regulatory reforms (especially in relation to China’s corporate finance regime). (3) “Negative List”. The draft Foreign Investment Law adopts a “negative list” approach in regulating market entry of foreign investors. This is a practice already somewhat tested in the China (Shanghai) Pilot Free Trade Zone. The State Council (China’s cabinet) will publish a “negative list” to set out industries where foreign investment is restricted or prohibited as well as investments that exceed certain investment amount thresholds set by the State Council. Foreign businesses not operating in industries identified as “restricted” or “prohibited” in the negative list with proposed investments below the related investment amount thresholds may proceed to corporate registration without the need for any market entry approval. Where a foreign business proposes to invest in an industry identified as “restricted” in the negative list or where the proposed investment (with all investment amounts made on the same project aggregated over any two-year period) should exceed investment amount thresholds, the foreign investor must apply with MOFCOM for market entry approval. (4) National Security Review. Chapter 4 of the draft Foreign Investment Law tries to flesh out the current national security review regime China created during Mr. Wen Jiabao’s tenure as China’s premier. The awakening of this dormant regime is not entirely a surprise given that the negative list approach outlined above would otherwise reduce government oversight over market entry by foreign investors. The scope of review (“where foreign investment infringes upon, or may infringe upon, national security”, a formulation seemingly modeled on the U.S. CFIUS approach) appears far broader than earlier references to the scope of such review. For example, according to the Circular of the General Office of the State Council on Establishing the National Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, the scope of national security review for M&A transactions covers “foreign investors’ acquisition of domestic military manufacturing and related ancillary enterprises, acquisition of enterprises in the vicinity of key and sensitive military facilities, and acquisition of other enterprises related to national defense; foreign investors’ acquisition of enterprises related to national security in such fields as involving important agricultural products, important energy and resources, important infrastructure, important transportation services, key technologies and major equipment manufacturing, which acquisition may result in foreign investors acquiring actual control of such domestic enterprises”. It would be interesting to see if the Foreign Investment Law (when promulgated) would exempt foreign greenfield investments from the national security review, as is the general practice in the U.S. (Chapter 4 currently does not appear to exempt greenfield investments). (5) FIEs to Be Treated as Foreign Investors. The draft Foreign Investment Law specifically provides that entities registered in China “controlled” by foreign investors will be treated as foreign investors. Under the current regime governed by the Existing Foreign Investment Laws, under certain conditions, FIEs can effectively be treated as domestic investors or players (and such treatment comes with certain benefits and conveniences, e.g., in respect of currency conversion, as well as certain limitations, e.g., with respect to available dispute resolution forums). While this "about face" in the treatment of FIEs is not entirely a surprise per practices of more developed nations in relation to national security issues, foreign investors will closely tally any benefits that will likely be chipped away by this new designation of FIEs, especially in areas where foreign investors may not otherwise receive "national treatment".(6) VIE Structure Still Necessary? Article 149 of the draft Foreign Investment Law proposes to impose heavy penalties on contractual schemes that circumvent Chinese foreign investment restrictions. Perhaps the most controversial of such schemes is the so-called variable interest entity or “VIE structure”. Currently, under some VIE structures foreign investors have financed Chinese businesses in “restricted” industries by owning and using a wholly foreign-owned vehicle to control a Chinese entity that possesses a coveted industry license, thereby receiving its economic benefits. As an example, many of China’s high-growth companies in ecommerce employ the VIE structure in one way or another. Under the Existing Foreign Investment Laws, some Chinese businesses would often have no way to raise international capital without employing the VIE structure. Article 45 of the draft Foreign Investment Law introduces a new concept whereby an entity incorporated in a foreign jurisdiction would nevertheless be certified by MOFCOM as a Chinese investor (not subject to foreign investment restrictions) provided that the foreign entity is “controlled” by Chinese investors. “Control” as defined in Article 18 not surprisingly covers three broad scenarios: (i) control of 50% or more of the voting rights, (ii) control of less than 50% of the voting rights but with the power to secure at least 50% of the board or with the voting power to materially influence the board or the shareholders meeting, and (iii) control through “decisive influence” (via contractual or trust arrangements) over a company’s operations, finances, human resources or technology. Article 18 therefore leaves the door open for Chinese companies to raise international financing through offshore vehicles provided that such offshore vehicles are “controlled” by Chinese investors within the meaning of Article 18. Arguably this obviates the need for many Chinese businesses to raise international financing through the VIE structure. (7) Treatment of Existing VIEs. The Explanatory Note suggests that MOFCOM will take further advice from the general public in respect of the vast inventory of VIE structures that exist on the market today (there appears to be an insatiable appetite among Chinese entrepreneurs to raise international financing, and, as noted above, in many cases they would not be able to raise such financing without the VIE structure under the Existing Foreign Investment Laws). It also suggests some possible approaches to deal with such existing VIE structures: (i) the parties may declare that the business is controlled by Chinese investors and the VIE structure can remain in place; (ii) MOFCOM may certify that the business is controlled by Chinese investors and the VIE structure can remain in place; and (iii) where the business is controlled by foreign investors, a market entry approval by MOFCOM will be required and MOFCOM will assess the situation based on a multitude of factors. There is no question that the draft Foreign Investment Law, if promulgated in its current form, will bring about far-reaching changes for foreign investment in China and China’s foreign investment regulatory regime. The firm is planning to submit comments on the draft law to MOFCOM (through AmCham Shanghai) prior to February 13, 2015. If you would like us to reflect any of your concerns in our comments, please feel free to contact any of us. 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Qiang Li, an O'Melveny partner licensed to practice law in New York, Wendy Pan, an O'Melveny partner licensed to practice law in New York and U.S. Patent and Trademark Office, Walker Wallace, an O'Melveny partner licensed to practice law in New York, Larry Sussman, an O'Melveny partner licensed to practice law in New York and Hong Kong, and Ning Zhang, an O'Melveny counsel licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted. Portions of this communication may contain attorney advertising. Prior results do not guarantee a similar outcome. Please direct all inquiries regarding New York's Rules of Professional Conduct to O’Melveny & Myers LLP, Times Square Tower, 7 Times Square, New York, NY, 10036, Phone:+1-212-326-2000. © 2015 O'Melveny & Myers LLP. All Rights Reserved.