China’s Foreign Investment Law (“FIL”) came into force on January 1, 2020, effecting far-reaching changes to the regulatory framework that has governed foreign investment in China for the last 40 years.
In many respects, the FIL is very good news for foreign investors, offering a more level playing field, a streamlined approach to the supervision of foreign investment, and enhanced investor protections. At the same time, there will be challenges for investors and government regulators alike given the lack of detailed guidance on implementation so far. The FIL stipulates only the broad principles to govern foreign investment. Practical impacts — including the effect of the FIL on cross-border M&A and on corporate governance in Chinese subsidiaries of foreign companies — depend on implementing rules.
This short guide offers a snapshot of China’s new framework for the regulation of foreign investment, highlighting key changes to China’s foreign investment system, some key benefits for foreign investors, areas of uncertainty that will need to be resolved in the coming months, and practical steps foreign investors need to take to adapt.
To appropriately deal with the FIL, you as a foreign investor in China should:
- Have a plan for adjusting the structures and constituent documents of your FIE subsidiaries;
- Strategize on how to comply with the FIL and leverage benefits under the FIL when undertaking a new investment;
- Be ready to follow the new foreign investment reporting system under the FIL;
- Actively monitor developments in the as-yet incomplete new framework.
- The FIL was promulgated on March 15, 2019, and came into effect on January 1, 2020, after a five-year legislative process that involved release of a first draft for comment in January 2015.
- In parallel with the coming into effect of the FIL, three legacy foreign investment statutes — the Law on Sino-Foreign Equity Joint Ventures (“EJV Law”), the Law on Sino-Foreign Co-operative Joint Ventures (“CJV Law”) and the Law on Wholly Foreign Owned Enterprises (together with the EJV Law and the CJV Law, “Three FIE Laws”) – have been repealed.
- Implementing Regulations for the Foreign Investment Law (the “Implementing Regulations”) were passed on December 12, 2019, and came into force along with the FIL on January 1, 2020.
- Both the FIL and its Implementing Regulations are short and drafted at a level of general principle (the FIL contains 42 clauses, in contrast to an initial, 2015 draft that included 170 clauses). Various other new regulations, and various legislative changes, needed to implement the FIL remain to be issued.
1. Key Changes
(References in this balance of the alert to the FIL include references to both the law itself and the Implementing Regulations, unless otherwise specified.)
1) Corporate governance unified. Repealing the Three FIE Laws involves repealing the separate corporate law framework that applies only to FIEs. Going forward, FIEs are subject to the same corporate law rules as domestically invested companies, as set out in the Company Law (or, where relevant, the Partnership Law). As discussed in section 2.1, this change offers investors new flexibility in the structuring and operation of FIEs.
2) Comprehensive definition of foreign investment. “Foreign investment” is defined broadly under the FIL. It includes greenfield investments via set-up of an FIE, M&A, and “new project investments,” which is defined as an investment in a specific project other than via set-up of an FIE or an M&A transaction. It expressly covers direct and indirect foreign investment, which will among other things draw into the scope of the FIL second-tier investments made within China by FIEs.
3) Codification of key recent foreign investment reforms. The FIL codifies into law a number of changes to the administration of foreign investment that have been introduced over the past number of years. One key example is use of “negative lists” to monitor foreign investment in specific sectors.
4) Integrated foreign investment reporting system. As discussed further in section 4.3 below, the FIL requires establishment of an integrated foreign investment reporting system for the submission of investment information to be submitted to MOFCOM via the enterprise registration and the “enterprise credit information publicity” systems administered by SAMR.
5) Primacy of national security. The FIL require a national security review (“NSR”) of any foreign investment that has or may have an impact on China’s national security. As discussed in section 3.3 below, the FIL omits details of the process.
6) IP protection. The FIL includes a number of provisions to address concerns among foreign investors about weak IP protection in China, including a prohibition against the use of administrative measures to force transfers of technology, a requirement that government authorities protect foreign investors’ business secrets, and enhanced remedies for IP infringement.
7) Foreign investor protections. The FIL sets out various measures for the encouragement and protection of foreign investment, including a formal entitlement of foreign investors to national treatment, an assurance that foreign investors can participate in the government procurement market, an assurance as to the ability of a foreign investor to remit lawful income out of China, and a restriction on expropriation.
2. Key Benefits for Foreign Investors
The FIL offers a range of benefits for foreign investors in the China market.
1) Move to more permissive corporate governance rules. The Three FIE Laws include relatively restrictive provisions governing issues such as the composition of the board of directors and requirements for unanimous consent, methods of capitalization of FIEs and other matters. In comparison, the Company Law leaves shareholders of an FIE with much greater latitude to agree to appropriate arrangements in the shareholders agreement and articles of association.
The chart below, which highlights differences between the EJV Law and the Company Law, illustrates the general point.
Board of directors
Approval for Key Major Matters
Unanimous consent of all directors present at a Board meeting
Shareholders representing two‑thirds or more of voting rights
The selling shareholder has to obtain consents from non-selling shareholders.
The selling shareholder needs to obtain consents of more than half of the other shareholders, and, if any other shareholder refuses the transfer but refuses to buy such shares to be transferred, then such shareholder shall be deemed to have consented to the transfer.
The Company Law also allows the shareholders to agree to a different share transfer mechanism, which gives more flexibility to shareholders on transfer of shares.
Distribution of Profits/Dividends
Must be in proportion to the parties’ actual capital contribution
Shareholders may decide on proportionate distributions or distributions via a different approach.
Quorum for Board Meetings
Two‑thirds or more of directors
No specific requirement, to be stipulated in the articles of association
2) Greater flexibility in funding FIEs.
The Three FIE Laws permitted investors to contribute capital to an FIE only with cash and specified IP and other property rights. The FIL permits an FIE to be capitalized using equity rights, allowing, among other things, for M&A transactions to be undertaken via share swaps.
The FIL also expressly contemplates FIEs using various financing methods on the same basis as domestic companies, such as the public issue of stocks, bonds and other securities. Historically no law prohibited an FIE from undertaking a public offering in China, but it was rare in practice. The FIL may facilitate FIEs’ use of the debt and equity markets in China to fund-raise.
3) Leveling of the playing field.
The FIL achieves this in two respects.
By entrenching use of negative lists, the FIL reduces the scope for discretionary administrative review of foreign investment transactions. This becomes more meaningful as negative lists have become shorter and more discrete.
The FIL also emphasizes a foreign investor’s right to national treatment in various areas, including eligibility to investment incentives, the right to comment on legislation, the right to participate in standard setting, and the right to participate in the government procurement market. The FIL also prohibits regulation of foreign investment via unpublished policies.
4) Enhanced protection of IP.
Foreign strategic investors have long expressed concerns regarding the protection of their intellectual property in China. In addition to weak civil remedies against infringers, Chinese laws and regulatory practices have often required IP holders to transfer trade secrets, know‑how and other sensitive IP to Chinese partners as a condition of participation in the China market. These issues formed the core of the WTO complaint filed against China in March 2018 by the U.S. government. The FIL seeks to improve matters by including:
- A prohibition against the use of administrative measures to force transfers of technology, and a recognition that the conditions of any intellectual property license are more properly a commercial matter for negotiation between the parties based on fairness. This is couched in very high-level terms, and only time will tell whether it will be effective to tackle this widespread issue. The Chinese government has taken some promising initial steps — notorious provisions in the 2001 Administrative Regulations on the Import and Export of Technologies that gave Chinese partners the statutory right to improve and own technology licensed from foreign companies as a condition of import, were abolished at around the same time that the FIL was promulgated. It is important to note, however, that the abolition did not expressly apply to certain interpretations of the PRC Contract Law by the Supreme People’s Court, which may continue to have a similar practical effect on technology sharing agreements governed by PRC law;
- a requirement that government authorities protect foreign investors’ business secrets. This is welcome reassurance given the historical difficulties in protecting non-registered IP rights in China due to the need for many types of sensitive IP agreement (e.g., technology import agreements and patent license agreements) to be registered with the authorities;
- enhanced remedies for IP infringement — the high‑level sentiments in the FIL have been implemented in an amendment to the PRC Trademark Law on November 1, and draft changes to the PRC Patent Law that both included raising punitive damages for malicious trademark infringement from three times to five times the actual losses and raising the cap on statutory damages from RMB 3,000,000 to RMB 5,000,000.
3. Lingering Uncertainties
With the broad drafting of the FIL, much has been left by the legislators to be clarified via implementing measures and policies. Issues that await clarification include the following:
1) VIE Issues. The first, 2015 draft of the FIL reflected a clear intent to restrict usage of the so‑called “variable interest entity” or “VIE structure” as a way to circumvent Chinese foreign investment rules. The enacted FIL omits these provisions of the first draft, likely to reduce controversy associated with the FIL in a period of heightened trade tension between China and the United States.
Does this indicate the Chinese government’s decision not to tackle use of the VIE structure or merely a decision to defer the issue? It is very possibly only the latter. The FIL definition of foreign investment includes indirect investments and a “catch-all” provision allowing the State Council to designate by regulation other investment forms as foreign investment. This open‑ended definition of foreign investment leaves ample room for the State Council to regulate VIEs in the future.
2) Non-FIE Foreign Investment. Uncertainty remains as to the scope of “new project investment” under the FIL. As noted above, the term is defined in the FIL as investment in a specific project other than via set-up of an FIE or an M&A transaction, with no further guidance yet.
The initial, 2015 draft FIL anticipated including cross-border financing of an FIE, natural resource and BOT projects, and real estate investments in the scope of “foreign investment.” We expect these types of transaction will likely be viewed as “new project investments.
3) National Security Review. The initial, 2015 draft FIL included a full chapter on the scope and procedures for conduct of NSRs of foreign investment transactions. The final FIL omits the details and simply contains a general statement that China will establish a security review regime. Comprehensive regulations may be issued in due course to update interim procedures put in place by the State Council in 2011. Meanwhile, China’s National Development and Reform Commission announced in April 2019 that it has taken over responsibility from MOFCOM for the conduct of NSRs of foreign investment.
4. Adapting to the new system
Different foreign investors will have different “to do” lists associated with the FIL, depending on their situation. Some suggestions below:
1) Have a plan for adjusting the structures and constituent documents of your FIE subsidiaries. As discussed above, they will ultimately need to be adjusted to follow the Company Law on the same basis as domestic companies. In the short term, making those adjustments may be difficult, without important transition procedures having been put in place. Thankfully, there is no rush, since the FIL provides for a five-year transition period to do so. But start to have a plan.
Any joint venture may present more challenges than a WFOE since the required adjustments will involve revisions to the joint venture contracts of joint ventures and possible renegotiation of corporate governance and other provisions. If the parties from a commercial perspective have other changes to make to a joint venture contract within the five-year grace period, then possibly they will need to discuss and agree to the FIL-driven changes at the same time. Foreign investors in JVs should have a plan for how to approach their JV partners about the adjustments required.
2) Strategize on new investments. There is no five-year grace period for new investment transactions. M&A transactions not already completed before December 31, 2019, new joint ventures, and new WFOE incorporations will need to reflect post-FIL requirements. Document templates will need to be adjusted and preferred governance structures reconsidered. Consult with knowledgeable legal counsel.
3) Be ready to follow the new reporting system. FIEs are subject to different reporting obligations going forward, which will involve submission of information into two systems administered by SAMR, with information to be shared between SAMR and MOFCOM. The timing, format, and content of information to be submitted differs from what FIEs have been required to submit to MOFCOM and SAMR historically. MOFCOM and SAMR both issued draft implementing rules on the new reporting system in early November 2019 for public comments. We expect these rules to be finalized early in the new year, and the new system may be implemented soon after that, with some inevitable teething pains for both FIEs and local counterparts of SAMR and of MOFCOM administering the system.
4) Monitor developments. Much uncertainty about the FIL will remain until additional implementing measures are issued and until amendments to other Chinese legislation are made to implement the FIL. It is critical therefore to actively monitor developments.