On August 23, 2019, just two days after Yonghui Supermarkets (601933,SH) announced clearance of the merger filing for its acquisition of a controlling stake in Zhongbai Group (000759,SZ) by the State Administration for Market Regulation of China (“SAMR”), the parties made another public announcement that Yonghui received a letter from the National Development and Reform Commission (“NDRC”), requesting Yonghui to submit the transaction for a national security review (“NSR”). On September 24, NDRC notified Yonghui of its formal case docketing. This is the first publicly reported NSR case since NDRC took over NSR’s coordination responsibility from the Ministry of Commerce (“MOFCOM”) this April.
As the largest marketplace worldwide and in response to the delicate global trade situations, China is striving to further its open-up and reform initiative, heralding fewer restrictions on foreign investment, and NSR is seen to become an increasingly important regulatory tool for government to oversee the economy following the more mature merger control regime. The Foreign Investment Law (“FIL”, which will become operative as of January 1, 2020) provides that “[t]he State establishes a foreign investment security review scheme to conduct security review of any foreign investment that affects or may affect national security”. With other major jurisdictions like the U.S. and EU strengthening their own national security review regime, China’s NSR could also be leveraged as a counteraction in response to prohibitive or restrictive investment measures against China’s investment offshore.
Against this backdrop, this note looks into the NSR practices in China by discussing the following questions:
▪ Q1: Which types of target will be caught by NSR in China?
▪ Q2: What are the instances of “Acquisitions” subject to NSR?
▪ Q3: What are the instances of gaining “effective control”?
▪ Q4: Who is in charge of NSR?
▪ Q5: How to start NSR and how does NSR interact with other regulatory approvals such as merger control?
▪ Q6: How much time does a typical NSR cost?
▪ Q7: What are the consequences of NSR?
Q1 Which types of target will be caught by NSR in China?
On February 3, 2011, the General Office of the State Council of China issued the Notice on Establishment of Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “State Council Notice”). The State Council Notice provides for the implementation of NSR for foreign investors’ mergers with and acquisitions of domestic companies within China (“Acquisition”) in industries and sectors where national security may be concerned.
Under the State Council Notice, there are two categories of Acquisitions that are subject to NSR notification:
(A) Acquisitions involving national defense security; and
(B) Acquisitions of Chinese enterprises engaged in key industries, which have a bearing on national security, whereby foreign investors may acquire an effective control over such enterprises.
For category (A) Acquisitions, effective control is not one of the required elements; therefore, even a minority interest in the PRC target gained by a foreign investor will trigger an NSR notification. This indicates the heightened sensitivity over transactions which may jeopardize China’s defense security.
For category (B) Acquisitions, the effective control threshold must be met in order to trigger an NSR notification. In addition, the list of sectors under category (B) cannot be understood to be an exhaustive one, which gives the regulator more discretion as to whether a transaction is subject to NSR. An alleged NSR sensitive sectors list, containing 57 sectors including retail, can still be found on the Internet, but never has it been officially published or acknowledged by any Chinese regulatory authority.
For category (B), it is also worth noting that the Notice on the Issuance of Pilot Measures for National Security Review of Foreign Investment in Pilot Free Trade Zones issued on Apr. 8, 2015 (“FTZ Notice”) added “important products and services concerning culture and information technology” into the NSR for foreign investment in pilot free trade zones on top of the national list, which echoes the National Security Law and the Cybersecurity Law, reiterating the significance of safeguarding cultural security and cybersecurity.
In addition, the Provisions on Ministry of Commerce’s Implementation of the Security Review in connection with Acquisition of Onshore Enterprises by Foreign Investors dated August 25, 2011 (“MOFCOM Implementation Provisions”) provides a catch-call clause (Article 9) by stipulating that “[w]ith regards to the Acquisition, the substances and actualimpact of the Acquisition shall be the ground for determining whether the Acquisition falls within the scope of NSR”. Also, the National Security Law, which took effect in 2015, also has a clause requiring NSR on any foreign investment which may have national security concern. All of such provisions allow China’s regulatory authority to have very wide discretion in determining whether certain transaction is subject to NSR.
Q2: What are the instances of “Acquisitions” subject to NSR?
As described in the State Council Notice, Acquisitions include the following instances:
- A foreign investor purchases the equity interests in a non-foreign-invested enterprise in China or subscribes the increased capital of a non-foreign-invested enterprise in China, thereby making such enterprise converted into and established as a foreign-invested enterprise (“FIE”);
- A foreign investor purchases the equity interests in an FIE from a Chinese shareholder or subscribes the increased capital of an FIE;
- A foreign investor establishes an FIE, through which, the foreign investor (A) purchases and operates the assets of an enterprise within China, or (B) purchases the equity interests in an enterprise within China;
- A foreign investor directly purchases the assets of an enterprise within China and use such assets to establish an FIE for operation of such assets.
In addition, the MOFCOM Implementation Provisions further provide that foreign investors shall not circumvent the substance review by any means, including but not limited to nominee shareholding, trust, multi-level on-ward investment, lease, loan, contractual arrangement or offshore transactions.
In Yonghui/Zhongbai deal, Yonghui’s largest shareholder is a Hong Kong company called Diary Farm International, and the transaction may be deemed as a foreign investor’s indirect acquisition of Zhongbai, a non-FIE, and thereby being caught by the instance of item (iii) above.
The wide scope of Acquisition indicates that for purposes of NSR, the authority focuses more on the substantive impact rather than the form of the transaction. Further, by observing the recent legislative trends, it appears that the concept of “Acquisitions” under NSR will likely be expanded to the broader scope of “foreign investment”. For instance, the FTZ Notice covers all kinds of “foreign investment”, either direct or indirect, for NSR purposes, including contractual control, beneficiary ownership, trust, reinvestment, overseas transactions, lease, subscription of convertible bonds, and so on. Also, the FIL generally requires NSR on any foreign investment that may have a bearing on national security.
Q3: What are the instances of gaining “effective control”?
As noted above in Q1, for the Acquisition involving defense security (category (A) above), effective control is not one of the required elements; for the Acquisition involving non-defense security (category (B) above), the effective control threshold must be met in order to trigger an NSR notification. “Effective control” under the State Council Notice contains the following instances:
- The combined percentage of shares in the post-Acquisition company held by a foreign investor and its parent with a controlling share and the subsidiaries in which it has a controlling share exceeds 50%;
- The combined percentage of shares in the post-Acquisition company held by two or more foreign investors exceeds 50%;
- The percentage of shares in the post-Acquisition company held a foreign investor is less than 50%, but the voting right vested upon such shares is sufficient to exert a material impact on the resolutions of the shareholders’ meeting, the general meeting of shareholders or the board of directors of such company; and
- foreign investors otherwise gain actual control of management decisions, financials, human resources, or technologies of the domestic company.
As for the Yonghui/Zhongbai deal, it remains to be seen whether it concerns national defense security. Based on Yonghui’s 2018 annual report, Dairy Farm International is its largest shareholder (19.99%), but it also states that Dairy Farm International is neither Yonghui’s controlling shareholder nor actual controller. If this were to be confirmed by the authority, then it is possible that this transaction is subject to NSR due to national defense security concerns.
What is noteworthy is the lack of reference of gaining effective control in the FTZ Notice and the FIL (incl. its 2015 exposure draft, which contains more detailed NSR provisions). Under the new NSR regime in the context of the FIL, this “effective control” test could be removed, further lowering the threshold and expanding the scope of NSR.
Q4: Who is in charge of NSR?
The State Council Notice provides that an Inter-ministerial Joint Committee (ICJ) will be established to undertake the NSR. The IJC shall be under the leadership of the State Council and coordinated by the NDRC and MOFCOM, carrying out NSR in conjunction with other governmental departments or agencies relevant to the industries and fields involved in the Acquisition.
MOFCOM used to act as the interface window for NSR notification and communications to applicants and forwarding the notification to the IJC for review. The MOFCOM Implementation Provisions set out more detailed responsibilities in this regard. However, the Yonghui/Zhongbai deal brought NDRC to the spotlight. Indeed, as of this April 30, NDRC has taken over the NSR interface responsibilities from MOFCOM due to “adjustment of ministerial functions”, including pre-consultation, application acceptance, preliminary review, and so on.
Q5: How to start NSR and how does NSR interact with other regulatory approvals such as merger control?
NSR procedures can be initiated by one of the following ways:
- where a contemplated Acquisition falls into the scope of NSR, the foreign investor shall submit an application to the authority in accordance with the requirement of the Notice and the Provisions; or
- third parties, including relevant department under the State Council, national industry association, any enterprise engaged in the same industry or upstream or downstream industries, may also submit a proposal to MOFCOM for initiating NSR if it believes that it is necessary to conduct NSR on certain Acquisition.
The MOFCOM Implementation Provisions make clear that no local authority may approve any Acquisition until relevant NSR is cleared. In practice, merger control provides a good opportunity for the relevant authorities to assess a specific transaction and its interaction with NSR. China’s merger control authority (now SAMR while MOFCOM used to be in this role before April 2018) is a member of the IJC for NSR. During merger review, SAMR can at its discretion solicit opinions from other governmental authorities, trade associations, suppliers, customers, competitors and/or other stakeholders. Such interactions could involve NSR related assessments and opinions. In addition, the merger filing notification form expressly requires the notifying parties to advise whether the contemplated transaction is also subject to other approvals, which is supposed to implicate NSR. In Yonghui/Zhongbai deal, SAMR was already reviewing the case when NDRC initiated NSR procedure -- it is possible that the NSR was triggered due to the interaction and information sharing among different regulators.
In practice, based on our experience and observation, merger control and NSR (and securities regulatory approval of a listed company) can be conducted in parallel. While the NSR followed the merger clearance in Yonghui/Zhongbai deal, it does not mean that the merger control is a pre-condition for starting NSR procedure. For effective process management, we recommend that the transaction parties get prepared for NSR assessment (and possible NSR filing) as early as practical.
Q6: How much time does a typical NSR cost?
NDRC will conduct a preliminary vetting of the NSR notifications to determine whether the proposed Acquisition falls within the scope of NSR, and if the answer is affirmative, it shall submit the application materials to the IJC for a general review, which may take up to 30 working days. If the IJC does not raise any NSR concern during the general review, it will give green light to the transaction. Otherwise, a special review procedure will be initiated, and the IJC shall complete the special review within sixty (60) working days.
In the special review stage, the IJC shall organize a security assessment on the transaction and base its review of the transaction on the assessment opinions. If a “general” consensus is reached among the IJC, it shall issue a review opinion (granting green light, requesting adjustment to the transaction, or prohibiting the transaction and requesting measures to eliminate any impact); if, however, there is a significant difference of opinions among the reviewers, the IJC shall submit the case to the State Council for a decision within sixty (60) working days from the date the special review procedure starts. The existing rules do not expressly provide how long it will take the State Council to decide on an NSR case referred to it by the IJC, thereby creating uncertainties as to the timing and prospects of the transaction, particularly for listed companies with public disclosure obligations. In light of this, it is very important for transaction parties to plan in advance and engage proper communications for various scenarios.
What are the consequences of NSR?
Depending on the impact the transaction may bear on national security, the authorities may make different decisions:
The FTZ Notice further introduces conditional approval mechanism, where the NSR authority may proactively discuss remedial measures with foreign investors to carry out the transaction after eliminating any national security concern. In contrast with the vague requirement under the State Council Notice, such mechanism provides a more practical path to resolving NSR concern and can reduce the transaction cost. Considering such mechanism also appeared in the FIL’s exposure draft and the established practice in merger control regime, we anticipate that the future NSR regime will likely include conditional approval mechanism.
Future NSR in the Context of the FIL?
The FIL, after eight years since NSR regime’s formal introduction in the State Council Notice, will for the first time establish NSR system at national law level in China. The past eight years have witnessed significant shift in domestic and international political/economic environment, which also calls for change of China’s NSR regime. It would be an art of balance between furthering opening-up and firmly safeguarding national security.
Regardless of the outcome of such change, we believe NSR will play an increasing role in future foreign investment in China, and we recommend foreign investors and their Chinese partners take it seriously and engage in proactive preparation and communications to further business success.