As a country with a civil law tradition, the People’s Republic of China has enacted its own written contract law that in large part adopted the UNIDROIT General Principles of International Commercial Contracts (an instrument reflecting the general principles of the international commercial contract law). However, in the area of Chinese contract law (for the purpose of this article, Chinese contract law refers to the contract law of mainland China, exclusive of Hong Kong, Macau or Taiwan), China has also kept some unique Chinese characteristics along with certain areas of uncertainty due to the limited experience of its comparatively young market economy and judicial system. Therefore, while the content of Chinese contract law is generally within the normal expectations of most non-Chinese parties, there remain certain special rules and areas of ambiguity.
As a result, foreign investors in mainland China often prefer to choose another legal system for reasons of familiarity and greater certainty. Unfortunately, their choice of governing law may be limited by their own negotiating strength in commercial transactions, as well as by various statutory restrictions under Chinese law. This article attempts to conduct a practical analysis of these statutory restrictions and their effects on the choice of law, with respect to mergers and acquisitions in China, and related implications that may arise from an uninformed choice of governing law.
General Principles on the Choice of Law Under Chinese Contract Laws
Chinese law tends to respect the will of parties to a “foreign-related” contract in choosing a non-Chinese governing law, subject to the statutory restrictions imposed by Chinese laws and regulations (Article 145 of the General Principles of the Civil Law of the People’s Republic of China and Article 126 of the Chinese Contract Law).
Whether a contract is foreign-related, therefore, becomes a precondition for the parties thereof to exercise the right of choice. In other words, contracts without foreign elements are governed by Chinese law. According to the judicial interpretations of the Supreme People’s Court (Article 178 of the Judicial Interpretation of the Supreme People’s Court on the Application of the General Principles of Civil Laws of the People’s Republic of China), to qualify as a foreign-related contract, the contract must meet one of the following conditions:
- At least one of the parties to the contract is “foreign.” For legal entities, this means that the place of incorporation must be outside mainland China; for individuals, citizenship must be non-Chinese.
- The subject matter of the contract is outside mainland China.
- The formation, modification or termination of contractual rights and obligations occurs outside mainland China.
The first two of the above items (foreign parties and subject matter) are comparatively straightforward, but uncertainty still exists as to the practical meaning of the third item (contractual rights and obligations outside mainland China). In particular, the mere fact that a contract was signed outside mainland China may not, in itself, be sufficient for the contract to be deemed as foreign related by the Chinese courts.
Chinese law further imposes the following mandatory restrictions on foreign-related contracts in the choice of non-Chinese law as the governing law (Articles 6 to 8 of the Regulations Regarding the Application of Laws for Foreign-Related Civil and Commercial Disputes dated July 23, 2007, issued by the Supreme People’s Court).
- Certain specific categories of contract must be governed by Chinese law, including most foreign-investment related contracts.
- The application of foreign law will be deemed invalid where it conflicts with the “public interests of the People’s Republic of China.”
- Foreign law will not be applied if the relevant choice of law represents an attempt by the parties to seek to avoid the application of mandatory provisions or prohibitions of the Chinese laws and regulations.
Contracts Governed by Chinese Law
While allowing parties to a foreign-related contract to select non-Chinese law as the applicable law for resolution of a contractual dispute, Chinese contract law also expressly provides that Chinese law must apply to Chinese-foreign equity joint venture (EJV) contracts, Chinese-foreign contractual joint venture (CJV) contracts, and contracts for Chinese-foreign joint exploration and development of natural resources that are performed in mainland China.
Moreover, according to the regulations issued by the Supreme People’s Court in 2007, the performance of the following additional foreign M&A-related contracts in mainland China must be governed by Chinese laws:
- Equity-interest transfer contracts of foreign-invested enterprises (FIEs)
- Contract-management contracts of EJVs and CJVs in China by foreign individuals, legal persons or other organizations (known collectively as “foreigners”)
- Contracts for the equity purchase of non-FIEs by foreigners
- Contracts for the subscription to increase registered capital of non-FIEs in China
- Contracts for the asset purchase of non-FIEs by foreigners
The above regulations are a judicial statement issued by the Supreme People’s Court with respect to judicial proceedings in mainland China. Non-judicial organizations are not necessarily bound by these regulations. Nevertheless, in practice, Chinese authorities such as the Ministry of Commerce (MOFCOM), which are charged with approving certain foreign M&A-related contracts, tend to adhere to the regulations.
General Policies on Foreign M&A in China
The Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises (the M&A Rules), enacted in 2006 by MOFCOM and five other ministerial government authorities, represented a major development in China’s regulation of foreign acquisitions of China-based companies and signaled government intentions to monitor and supervise such foreign M&A activities in China to an even greater extent.
The M&A Rules set forth the general principles governing M&A activities by foreign investors in China, including the following statutory obligations of the parties to such M&A transactions:
- To abide by the laws, administrative regulations and rules of China, comply with the principles of fairness, reasonableness, compensation for equal value and good faith, and avoid causing excessive centralization, excluding or limiting competition, disturbing the social economic order, damaging the public interests, or other actions resulting in any loss to state-owned assets (Article 3 of the M&A Rules)
- To satisfy the requirements of the laws, administrative regulations and rules of China concerning the qualifications of investors, and to comply with policies on industry, land, environmental protection, etc. (Article 4 of the M&A Rules)
- To follow relevant provisions on the management of state-owned assets, if the acquisition of a domestic enterprise involves the transfer of state-owned property rights of the enterprise and management of state-owned property rights of listed companies (Article 5 of the M&A Rules)
- To pay taxes under Chinese tax laws and accept the supervision of tax authorities (Article 7 of the M&A Rules)
- To abide by the laws and administrative regulations of China on the administration of foreign exchange and to follow approval, registry, archival filing and modification formalities of foreign exchange control authorities (Article 8 of the M&A Rules)
In addition to the tightened regulation on M&A activities that may result in either a concentration of control in a given industry or control of companies in industries that are considered “key” and “sensitive” in the Chinese economy, the M&A Rules also stress the necessity of protecting national economic security in the context of foreign acquisition of domestic enterprises. Thus, the M&A Rules dictate that foreign investors must comply with MOFCOM reporting requirements in connection with acquisitions of domestic target companies engaged in key industrial sectors that affect or may affect the security of the national economy, or in connection with acquisitions of domestic target companies holding well-known trademarks or traditional brands in China (Article 12 of the M&A Rules).
To ensure compliance with the above statutory requirements by foreign investors, the M&A Rules also set forth a detailed examination and approval mechanism, including MOFCOM approval and State Administration for Industry and Commerce registration of any foreign-invested enterprises established from the acquisition by foreign investors, approval by China Securities Regulatory Commission for offshore listing of domestic equity or assets, MOFCOM approval and State Administration of Foreign Exchange registration for round-trip investments conducted by special-purpose vehicles, antitrust review by MOFCOM, national economic security reporting, etc.
Implications of Restrictions on Choosing Foreign Law as Governing Law
Given the above-noted legal restrictions on the choice of foreign laws, as well as the mandatory policies governing foreign M&A transactions in China, choosing non-Chinese law as the applicable law for M&A contracts may become very problematic.
In particular, issues may arise when approval for an M&A contract is required from Chinese governmental authorities. In practice, it is not uncommon for Chinese governmental authorities to refuse to approve certain M&A transactions until the foreign governing law in such contracts has been changed to Chinese law.
When disputes regarding such M&A contracts must be resolved in mainland China, the choice of foreign law, in contravention of the above-noted restrictions and M&A policies, will be regarded as invalid by the Chinese courts or arbitral tribunals. An invalid choice of law will thus create great uncertainty in determining the contractual rights and duties of the disputed parties under the contract.
If the M&A contract provides for arbitration in a foreign jurisdiction to resolve disputes, then a foreign tribunal may well respect the choice of law in applying conflict-of-laws principles of the foreign jurisdiction where the arbitration is conducted. However, if the counterparty is Chinese or has considerable assets located in China, there is a risk that a Chinese court could refuse to enforce any award rendered by that tribunal on grounds of violation of Chinese public policy.
Even if the choice of foreign law in the M&A contract is deemed valid, the parties must comply with mandatory policies governing M&A activities in China. Any violation of these mandatory provisions or prohibitions under Chinese laws may render the validity or performance of such M&A contracts problematic.
To avoid or mitigate potential risks in choosing foreign law as governing law for M&A contracts in China, it is usually advisable to acknowledge the above-noted legal restrictions and mandatory M&A policies by opting for Chinese governing law. In such cases, the foreign investor should have a qualified professional review the M&A contract and monitor the performance thereof to ensure that it takes into account differences between Chinese contract law and the contract law system with which the foreign investor is familiar.