On 3 February 2011 a new circular entitled Circular of the General Office of the State Council on the Establishment of a Security Review System Regarding Mergers and Acquisition of Domestic Enterprises by Foreign Investors was published by China’s State Council. The circular provides for the implementation of certain national security review processes that are referenced in the Anti-Monopoly Law (AML), and which will operate in parallel to the AML’s anti-monopoly merger review provisions (Anti-Monopoly Merger Review).
Specifically, the circular establishes a multi-agency panel (Panel) that will assess the extent to which a proposed foreign investment in, or acquisition of, a domestic Chinese enterprise raises certain national security or related concerns (Security Review). After completing a Security Review in relation to a proposed transaction, the Panel will effectively have the power to block the deal, or impose conditions on it, if it considers that such measures are appropriate to address the identified concerns.
Key aspects of the new Security Review process are summarised in this legal update.
Transactions to which a Security Review will apply
According to the circular, the Security Review process will apply to transactions that:
- result in a domestic Chinese enterprise coming under foreign control; and
- concern a relevant industry sector in China (Security Review Sector).
The circular outlines several types of transaction that may result in a Chinese enterprise coming under foreign control (such as where a foreign investor purchases an equity interest in a domestic enterprise, or incorporates a foreign-invested enterprise to purchase and operate the assets of a domestic enterprise), and specifies that a foreign business operator intending to implement such a transaction is required to apply to China’s Ministry of Commerce (Mofcom) to ascertain whether a Security Review is required. Nothing in the circular suggests that such applications need only be made where the proposed transaction clearly relates to a Security Review Sector. However, it is possible that later implementation guidelines and regulations will address this issue and provide more clarity on exactly how and in what form notifications should be made.
Once it receives a relevant application, Mofcom will confirm whether the proposed transaction qualifies for a Security Review. This will necessarily involve consideration of whether the proposed transaction concerns a Security Review Sector. If so, Mofcom will submit the case to the Panel within five days for commencement of the Security Review.
When will a domestic Chinese enterprise be considered to come under foreign control?
As noted above, the circular refers to the acquisition by a foreign investor of an equity interest in a domestic enterprise as one of the types of transactions that may result in a Chinese enterprise coming under foreign control. In this context, it is noted that the circular specifies that a domestic Chinese enterprise will be deemed to be foreign-controlled once:
- the total shareholding of a single foreign investor (including its parent company and subsidiaries) exceeds 50 percent, or once the total shares of several foreign investors exceed 50 percent; or
- notwithstanding that the total shareholding in the domestic Chinese enterprise by foreign investors is 50 percent or less, those foreign investors have control over the management and operation of the domestic Chinese enterprise via the holding of relevant voting or other rights.
The circular confirms that investors located in Hong Kong, Macau and Taiwan will be considered to be foreign investors for the purposes of the Security Review process.
It is noted that little guidance is provided in the circular regarding the circumstances in which voting or other rights accompanying minority shareholdings will be considered to provide the minority shareholder with control over the invested enterprise. This mirrors the situation under implementation guidelines pertaining to an Anti-Monopoly Merger Review, which form of review is also usually only triggered if control is acquired over a target enterprise.
What are the relevant Security Review Sectors in China?
According to the circular, the Security Review process will target M&A deals concerning Chinese enterprises operating in any of the following Security Review Sectors: national defence, key agricultural products, key basic infrastructure, key energy and resources, major equipment manufacturing, key technology, and key transportation services.
Notably, some of these Security Review Sectors overlap with the nine “pillar industries” announced by China’s State Council and State Assets Supervision and Administration Commission in December 2006 as sectors in which state-owned enterprises should play a leading role.
The circular also states that the PRC government will issue separate security review regulations for foreign companies engaged in relevant foreign investments in or acquisitions of domestic financial institutions, but when these regulations may surface remains unclear.
Government agencies, trade associations, competitors, suppliers and other related parties may also refer foreign investment or acquisition transactions to Mofcom for Security Review.
What will the national Security Review process focus on?
Article II of the circular sets out four broad areas that will be the focus of a Security Review. These are the proposed transaction’s impact on (i) national security, (ii) the stable operation of the national economy, (iii) basic social order, and (iv) the research and development capabilities of key national security technologies.
In relation to national security, the circular indicates that Security Review will, in particular, consider the effect of the relevant transaction on the target enterprise’s ability to produce goods for the domestic market, services, equipment, and facilities relating to national security. No elaboration is provided in relation to the other areas of focus mentioned in the circular.
The broad terminology used in the circular, and in particular, the ability of the Panel to make reference to the impact of a transaction on the stable operation of China’s economy and social order, will allow the Panel wide discretion to scrutinise and restrict foreign investment in China that is seen to be at odds with the country’s unique socialist market economy and social development goals.
Further, while the scope of Security Review Sectors is limited, it is noted that the Anti-Monopoly Merger Review already allows Mofcom to consider the impact of any proposed transaction (whether or not conducted inside China) on China’s national economic development and industrial policy goals. Indeed, there is speculation that such considerations played a key role in Mofcom’s only prohibition decision under the Anti-Monopoly Merger Review system so far - the veto of Coca-Cola’s proposed acquisition of China’s Huiyuan Juice Group in March 2009.
Composition of the Panel
According to the circular, the new Panel that will conduct Security Review (the full name of which is the ‘Cross-Ministry Joint Panel System for Security Review of Foreign M&A of Domestic Enterprises’) will be officially led by China’s chief administrative authority, the State Council. However, the circular indicates that the actual process of review will mainly be conducted by representatives of Mofcom and the National Development and Reform Commission (NDRC). As described below, the State Council’s role will, it appears, be limited to considering cases where the opinion of the Panel is divided.
Security Review process and timing
Security Review will occur in either one or two stages, mirroring the review process that applies for Anti-Monopoly Merger Review.
Once the Panel commences Security Review in relation to a proposed transaction, the initial general review process can last up to 30 business days.
This process of general review will be conducted by collecting written comments from relevant government agencies. According to the circular, if all relevant agencies that the Panel consults in relation to a proposed transaction deem that it will not affect national security, the Panel will notify Mofcom in writing and effectively clear the transaction to proceed (subject to any other required regulatory approvals, such as Anti-Monopoly Merger Review approval).
Applications that fail to receive approval during the general review (i.e. one or more agencies consulted by the Panel believe relevant security issues are raised by the proposed transaction) will face an additional special review period of up to 60 business days. The special review process will consist of specific security assessment by the Panel itself. If, at the end of such assessment, the Panel are “largely unanimous” in their decision, they will advise Mofcom in writing. If there are “significant differences in opinion” within the Panel, the case will be submitted to the State Council for consideration.
The outcome of Security Review cases will be communicated to relevant parties by Mofcom.
Relationship with the AML and other regulatory approval processes in China
As noted at the beginning of this legal update, it appears the Security Review process will run in parallel to any Anti-Monopoly Merger Review. Accordingly, where a foreign investor proposes to acquire or take a relevant stake in a domestic Chinese enterprise, and that transaction triggers the mandatory anti-monopoly pre-notification provisions in Chapter IV of the AML, then it appears two notifications may need to be made - one to Mofcom’s Anti-Monopoly Bureau and one to a separate part of Mofcom involved in referring cases to the new Panel.
In some cases, for example where the turnover of the parties involved in a relevant transaction does not trigger the mandatory anti-monopoly pre-notification provisions, only notification to the latter may be required.
Parallels with other regimes
China is not alone in implementing a Security Review process. Many countries, including the U.S., Canada and Australia have already provided government agencies with the power to block or impose conditions on foreign investment proposals which are deemed to raise national security concerns.
In this context it is interesting to note that the Committee on Foreign Investment in the United States (CFIUS) has, at the date of writing, raised concerns about the national security implications of the acquisition by China’s Huawei Technologies Co. of the assets of U.S. company 3Leaf Systems. Some press reports have suggested there is a strong likelihood the acquisition will now be disallowed.
Previous CFIUS reviews have resulted in the abandonment of several transactions involving PRC investors seeking to acquire U.S. businesses or assets, and Australia’s Foreign Investment Review Board has also rejected several proposed deals in recent years that would have provided Chinese enterprises with significant interests in Australian mining and resources enterprises.
In this context, some analysts have expressed concern that the Panel may be tempted to wield its powers under the Security Review process in a way that is as much about reacting to the decisions of foreign security regulators as it is based on genuine appraisal of the security issues that may be raised by specific deals.
The new circular implements a further layer of regulation and review for foreign investments in China, and the international community will watch closely to see the extent to which the Panel takes advantage of its broad powers to identify security-related concerns arising from proposed transactions and then block or impose conditions on them. For now, companies looking to make acquisitions in China or acquire control of domestic companies, particularly in sensitive sectors, will need to be aware of the need to apply to Mofcom for Security Review and approval of relevant deals, and consider how this process may impact the timing and overall prospects of such deals.
However, it must also be recognised that the Chinese authorities already possess a broad range of powers to curb foreign investment, including via the Anti-Monopoly Merger Review process, the Rules on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (which allow Mofcom to challenge transactions in which foreign investors will acquire control of domestic entities in key economic sectors or affecting national economic security or famous Chinese brands) and other regulatory approval mechanisms. These mechanisms have also been used to force or pressure the abandonment of a number of major foreign investment proposals in China, including the previously mentioned Coca-Cola/Huiyuan deal and the bid by U.S. private equity firm Carlyle Group to buy a stake in China construction equipment manufacturer Xugong Group in 2005.
Accordingly, while the Security Review process may not add another layer of regulation to inbound deals and raise the prospect of transaction delays, it is unlikely to significantly alter the existing risk profile for foreign investment in China.
Usefully, introductory wording in the new circular expressly recognises that foreign M&A and investment in China “has promoted the diversification of foreign investment utilisation and contributed to the optimisation of resource allocation, technology improvements, and the development of enterprise management”. While it remains to be seen whether the Panel’s decisions will demonstrate an ongoing recognition and support of such benefits from foreign investment, foreign businesses will be encouraged by the inclusion of such wording in the circular and the fact that since its publication NDRC officials have been keen to publicly stress that China will not use the Panel as a weapon to block normal foreign investments.
Finally, with the new process set to commence on 5 March 2011, it remains unclear whether it will apply to proposed transactions already awaiting Anti-Monopoly Merger Review at that time. It is suggested that consultation with Mofcom should occur in relation to any such transactions to obtain clarity. In the interim, it is hoped that the Chinese authorities will quickly publish implementation guidelines and regulations to clarify other key matters- such as the precise circumstances in which foreign investors need to apply to Mofcom regarding Security Review, and how and in what form such notifications should be made.