On January 19, 2015, the PRC Ministry of Commerce unveiled the draft Foreign Investment Law for public comments until February 17, 2015. This article highlights how the draft law proposes to overhaul the Chinese foreign investment regime.

Moving away from entity­based regulations and nationwide adoption of “negative list” approach

Since the country opened up for investment in late 1970’s, China has built up its two­prong legal framework on foreign investment by primarily regulating the forms of legal entities that foreign investors may set up in China, and governing what types of business activities different forms of entities may respective undertake. This is illustrated by the sequential emergence of foreign invested EJVs in 1979, WFOEs in 1986, CJVs in 1988, joint stock companies in 1995 and limited partnerships in 2010, respectively. On the other hand, foreign investments projects are currently classified into “encouraged”, “permitted”, “restricted” and “prohibited” categories, which are subject to different forms of foreign ownership restrictions and approval requirements.

Under the draft law, corporate vehicles available to Chinese nationals will be generally available to foreign investors and the “negative list” approach first adopted by the Shanghai Free Zone in 2013 will be implemented nationwide. That means, unless it falls within the restricted or prohibited list , any foreign investment project will be subject to post­event recordal and regular reporting without obtaining prior approval from Chinese government authorities.

Refining National Security Review

The Chine national security review regime, first introduced in 2011, requires a foreign investor to obtain clearance from a joint­ministry panel before acquiring certain sensitive targets. At that time, sensitive targets include those engage in business relating to national defense/security, and agricultural products, energy/resources, infrastructure facilities or transportation services that are important, key technologies and major equipment are subject to such review.

The 11­chapter draft law has one chapter dedicated to refine the security review process. First, the targeted scope of M&A activities are expanded to include any foreign investment that harms or may potentially harm national security will be subject to review. Second, a total of 10 specific items (such as implications on national defense facilities, R&D capabilities, information and network security, etc) and a catch­all clause are listed as factors that will be taken into considerations. Third, the foreign investment authority may order and/or implement appropriate measures to neutralize any harm to national security. Forth, it is proposed that decisions of the review process are immune from review by administrative bodies or courts. Finally, separate regulations will be issued to deal with the review of targets in the financial sector.

Reporting and disclosure requirements

For most foreign investors, the routine of dealing with Chinese authorities will mainly comprise the compilation of reports and filings as follows:

Event­specific Filings

Under the new regime, a foreign investor will have to file a report before, or within 30 days after, the “implementation of an investment”, which means the date on which registration with the relevant Chinese authority is required or (if no such registration is required) the date of completion. A supplementary report will have to be filed within 30 days after a material change has occurred in respect of a foreign investor, such as its name, registered address, actual controller, principal business or contact person.

Annual and quarterly reports

Similar to the annual filing requirements launched in 2014, a foreign­invested enterprise will have to file an annual report before April 30 every year on relevant matters concerning the foreign investor and the foreign­ invested company. Where a foreign investment does not involve the setting up or changes to a foreign­invested company, the foreign investor itself will have to file a short form report about itself and the foreign investment made.

In addition, foreign­invested enterprises with more than 10 subsidiaries, or whose total assets, sales or business revenue exceeds RMB10 billion (about USD1,667 million) will have to submit a quarterly report on the business operations and financial/accounting information.

Credit reports and penalties for failure to comply

To implement the new compliance­based regulatory framework, the draft law has provisions to both incentivizes compliance and deter non­compliance.

On the positive side, the Chinese foreign investment authority will establish a “credit reports” system to collect and reflect information on the creditworthiness of foreign investors and their investee companies. The system will capture information generated during the establishment and operation of foreign­invested enterprises, as well as information collected by the Chinese authorities during the course of their supervisory duties. The credit information will be available for public searches in accordance with relevant regulations to be enacted.

On the deterrence side, the draft law imposes various monetary fines – ranging between RMB50,000 to RMB1,000,000 or 10% of the investment amount (see Important Terms below) – for non­compliance, or revoke the relevant entry permit (see Important Terms Below). More importantly, criminal liability will be imposed if foreign investors or their investee companies refuse to comply with their reporting/filing obligations or provide false information, which is punishable by fines on the legal entity and detention of not more than 12 months for the responsible management personnel.

VIEs and transitional arrangements

In a carefully measured move, the Ministry of Commerce has chosen not to adopt or propose a definite position in the draft law in respect of “contractual control arrangements” or commonly known as variable interest entities (or VIEs), pursuant to which foreign investors control – through an extensive contractual framework ­ the operations and income stream of PRC businesses that are subject to foreign ownership restrictions. That has been an “open secret” which the Chinese government has chosen not to take enforcement actions in most cases, and most internet businesses which have been floated in overseas stock exchanges use this model, including Alibaba which completed its records­breaking IPO on NYSE in 2014. As such, the general consensus is not so much whether the VIE arrangements can continue to exist, but rather how to validate the existence.

The explanatory notes to the draft law highlight three alternatives for vetting VIE arrangements:

Alternative 1:

Foreign­invested enterprises subject to VIE arrangements will declare to the foreign investment authority that they are subject to control by Chinese investors.

Alternative 2:

Foreign­invested enterprises subject to VIE arrangements apply for certification from the foreign investment authority that they are subject to control by Chinese investors.

Alternative 3:

Foreign­invested enterprises subject to VIE arrangements apply for relevant entry permit(s) from the foreign investment authority, which will, jointly with other relevant Chinese authorities, examine the application based on all relevant factors, including whether the entities are subject to control by Chinese investors.

It is contemplated that the existing EJV Law, CJV Law and WFOE Law will be repealed when the draft law enters into effect. To the extent existing EJVs or CJVs will continue to operate for more than 3 years after the new law comes into effect, they will have to comply with the corporate governance structure in accordance with the PRC Company Law. Practically that means EJVs and CJVs’ respective board of directors will become subordinated to a newly added shareholders meeting as the companies top decision­making body.

Important Terms

Foreign investors:

Includes juristic and natural persons, and Chinese individuals who have acquired foreign nationality

Foreign investment:

Includes the setting up of domestic enterprises or the acquisition of shares or voting rights thereof, the provision of loans of one year or above, obtaining the grant of franchise to explore natural resources or to build/operate infrastructure facilities, the acquisition of interests in immovable property, or the acquisition of interest in domestic enterprises by way of contractual control or trusts

Entry permit:

A permit issued by the foreign investment authority for investing in an industry listed in the “restricted catalogue for foreign investment”

Industry permit:

An industry­specific permit that is usually granted by other authority­in­charge

Investment amount:

Includes both equity investment and debt investment of one year or above; and investments made within two years on the same subject matter will be aggregated