On January 19, 2015, the Ministry of Commerce (“MOFCOM”) of the People’s Republic of China (“PRC”) released a draft of a proposed new Foreign Investment Law (the “Draft Law”) for public comment and an accompanying explanatory note (the “Note”). MOFCOM will seek input from the local and international legal communities on the Draft Law until February 18, 2015.

The Draft Law, if promulgated in its current form, would represent a major shift in China’s foreign investment regime. Key highlights include:

Unification of Foreign Investment Laws

The Draft Law would replace the three main current foreign investment laws (i.e., the Wholly Foreign-Owned Enterprise Law, the Sino-Foreign Equity Joint Venture Law, and the Sino-Foreign Cooperative Joint Venture Law) so that, going forward, a single, unified body of foreign investment law would govern all foreign investments in China, and foreign and domestic investors would, with certain limitations, be treated virtually the same.

Negative List Replaces the Catalogue

Under the current legal regime, in order to establish a new business in China, foreign investors must:

  1. first determine how a proposed project is categorized by making reference to the Foreign Investment Industrial Guidance Catalogue (the “Catalogue”)—which MOFCOM and the National Development and Reform Commission (the “NDRC”) last updated in 2011;
  2. then, generally (depending on the specific industry sector), apply to the MOFCOM and NDRC for an “approval” to enter into the Chinese market in order to set up and operate the project; and
  3. once the approvals are obtained, finally apply to the relevant office of the State Administration of Industry and Commerce (“SAIC”) for the new entity’s business license.

Note: The Catalogue lists areas into which foreign investment projects are “encouraged,” “restricted,” or “prohibited.” Foreign investment projects not listed in the Catalogue are generally considered to be “permitted.” This is important because the Catalogue-classification for any particular project is usually the key factor that the NDRC and MOFCOM consider before they approve it. Thus, if a project is “encouraged” or “allowed,” then it is likely that it will be approved. If, on the other hand, it is “restricted” or “prohibited,” then it is unlikely to be approved barring special circumstances (e.g., a minority joint venture arrangement).

The Draft Law, instead, adopts a “negative list,” which will be published by the State Council at a later date and will replace the Catalogue. The negative list will set out industries where foreign investment is “restricted” or “prohibited” only and, in some industries, specific investment amount thresholds.

  1. Like the current legal regime, pre-approval will be required for “restricted” projects. Specifically, foreign investors with projects that are “restricted” must apply for “market entry licensing” to the relevant competent foreign investment department (we assume that this department will continue to be the NDRC, MOFCOM, or both—but the Draft Law is not clear on who this authority will ultimately be).
  2. Unlike the current legal regime, however, the Draft Law does not require pre-approval or market entry licensing for foreign investors setting up projects that are not on the negative list. Instead, these foreign investors need only submit an investment information report to a “foreign investment information reporting system” within 30 days after the completion of the investment transaction.

Foreign Control Through a VIE Structure Will be Treated the Same as a Foreign Direct Investment

Under the current legal regime, foreign investors wishing to invest in the “restricted” category have often times employed contractual and other mechanisms (e.g., share pledges, voting proxies, management contracts, and so on) to allow them to gain indirect control over the Chinese entity. These structures usually involve a special vehicle set up in China (e.g., a consulting wholly foreign owned entity) for these purposes. These “controlling entities” are generally known as variable interest entities (“VIEs”) and have been adopted by many companies (both public and private) located outside of China.

Current PRC laws do directly not address VIE structures—thus billions of dollars of foreign funds have been allowed to flow into the PRC with offshore investors relying on the VIE structure to protect their interests. The Draft Law will now recognize VIE structures and provides that Chinese companies which are “foreign controlled,” directly or indirectly, by an offshore investor (i.e., via a VIE structure) will be treated as “foreign invested.” This means that if MOFCOM finds that a Chinese entity—which operates in a restricted or prohibited area—is effectively “controlled” by a foreign entity through a VIE structure, then it may treat the VIE structure as a foreign direct investment and, therefore, subject it to the approval/market entry licensing process noted above.

It is here that the Draft Law becomes disturbingly silent about what happens next. That is to say, the Draft Law fails to directly address how the Chinese authorities will approach all of the existing VIEs. Instead the Note offers the following three possible approaches for which MOFCOM has invited public comment:

  1. If a Chinese investor actually has “control” over the Chinese entity which is the subject of the VIE structure, then the arrangement may continue after that entity:
    1. files a statement with the foreign investment department that it is “Chinese-controlled”; or
    2. applies for a confirmation from the foreign investment department that in fact the entity is “Chinese-controlled”; or
  2. If, on the other hand, the VIE structure is controlled by a foreign investor, then the VIE must apply for “access permission” and the foreign investment department will decide whether to allow the VIE structure to continue to exist based on an “overall consideration [of the facts including who actually controls] the foreign investor [in the VIE structure] and other elements.”

In respect of points (a)(i) and (ii) above, MOFCOM has offered the following further explanation in the Note: only VIE structures with Chinese-controlled investors will be allowed to continue to operate with their existing structures. The approach under point (b), on the other hand, leaves room for the “foreign investment department” to decide on an ad hoc basis whether to allow a particular VIE structure with a foreign control to continue to exist.

Obviously this could have a profound impact on the value of companies that have relied on VIE structures as a part of their overall business in that, if all such VIE structures are suddenly deemed “invalid” or “illegal,” share values could plummet. One hopes that the Central government has taken or will take this risk into consideration before passing a final version of this law. The Draft Law is open for public comment until February 17, 2015. We will continue to monitor this important development, but in the meantime, please feel free to discuss any aspect of this briefing with Brinton M. Scott in Shanghai.