It has been more than two months since China’s new Foreign Investment Law (FIL) was passed at the second session of the 13th National People’s Congress (NPC) of China on 15 March 2019. Some thought the FIL was an indication that the US-China trade talks would soon be wrapped up. This is unlikely. Despite this the FIL has shown China reiterating a willingness to deepen reform and open up its economy.
The FIL, to be effective on 1 January 2020, is largely welcomed globally. It shows the Chinese government’s addressing concerns voiced by international companies such as forced technology transfers; level playing field for foreign invested companies; protection of intellectual property rights and access to public procurement projects.
In respect of improving the protection of IP rights China has emphasized – as much for its internal development as to placate overseas rights holders – on improving the rights of IP holders as well as the enforcement of such rights. Problems still exist but the situation is far better than it was even 5 years ago. China’s government also moved to remove requirements that forced technology transfers (i.e. time limits; continued use after expiration; ownership of improvements; etc.).
The FIL will replace the three existing PRC laws on foreign investment passed between 1979 and 1990, namely the Law on Sino-Foreign Equity Joint Ventures (EJV Law), the Law on Sino-Foreign Contractual Joint Ventures (CJV Law) and the Law on Wholly Foreign Owned Enterprises (WFOE Law, EJV Law and CJV Law collectively referred to as JV Laws, together with WFOE Law, Three FDI Laws).
Promulgated at the early stage of China’s reform and opening-up, the Three FDI Laws have laid a solid foundation to attract foreign investment. By the end of 2018, around 960,000 foreign-invested enterprises (FIEs) had been set up in China, and the actual use of foreign capital had exceeded 2.1 trillion US dollars. China’s actual use of foreign capital in 2018 reached 134.97 billion US dollars (excluding bank, securities and insurance section), about 12 times the amount in 1992 and 150 times the amount in 1983, now ranking second in the world.[i]
Despite the tremendous contribution, the Three FDI Laws have gradually fallen behind the dynamic market reality and could hardly address the emerging challenges with respect to foreign investment. For example, the Three FDI Laws mainly focus on greenfield investment (i.e. foreign direct investment), while other forms of investment, such as M&A and capital increase subscription, are not covered. In addition, the inconsistency between the Three FDI Laws and China’s Company Law becomes apparent over the years, especially the inflexibility of corporate governance under the JV Laws has tied over 300,000 Sino-foreign joint ventures in China.
A few regulations have been passed with the attempt to fill the gap left by the Three FDI Laws. In the autumn of 2013, Chinese government launched the first free trade zone in Shanghai which carried out a pilot scheme including pre-establishment national treatment with a negative list with the aim to further opening up and simplifying administrative procedures for foreign-invested enterprises. For this purpose, certain articles of the Three FDI Laws have been ceased to operate within the Shanghai free trade zone. As the pilot scheme went smoothly, the experience was afterwards spread nationwide and on its fifth anniversary in 2018, there were a total of 12 free trade zones in China.
There has already been a noticeable trend in China over the last 20 years of the authorities opening China’s market to foreign investment. The world’s biggest market still presents challenges but for most sectors there are limited legal hurdles to overcome. Most sectors are already open to foreign investment (i.e. no prohibition or requirement to have a Chinese partner) and indeed most FIEs established in China are wholly foreign-owned enterprises (WFOEs).
Key Impact of FIL on Existing FIEs
Below we set out the key impact of the FIL on existing FIEs:
As noted above, the FIL will replace the Three FDI Laws from 1 January 2020 and by that time the organizational form, corporate structure and operating rules of new FIEs will be subject to the China’s Company Law and the Partnership Enterprise Law[ii] For existing FIEs, they can remain their corporate structure etc. unchanged for five years starting from the effectiveness of the FIL, i.e. 1st January 2020.[iii]. Upon the expiration of the 5-year transition period, all FIEs shall be governed by PRC Company Law or the Partnership Enterprise Law. Given partnership is barely adopted in practice for joint ventures, most FIEs will need to follow the Company Law.
We believe the FIL will have very limited impact on WFOEs on corporate governance as the organizational form and corporate structure of WFOEs have been governed by the Company Law since 2006. In accordance with an implementation opinion published by four China ministerial authorities on 24 April 2006[iv], corporate governance of the WFOEs should follow the Company Law, including that the highest authority of a WFOE should be the board of shareholders rather than the board of directors.
In contrast with the WFOEs, the FIL will have a major impact on the existing joint ventures. The main reason is that the organizational form and corporate structure under the JV Laws are radically different from those set out under the Company Law. The one constant is that corporate governance in China JVs protects minority shareholders; constrains freedom of contract and absence of agreement will normally lead to gridlock and an inability to move forward. The coming changes will allow existing joint ventures to be restructured (subject to the caveats outlined here) to models that better allow for the majority shareholder to take decisive action.
Below table shows the key difference on the corporate structure and governance under the JV Laws and the Company Law:
From the table above, it is clear that in the 5-year transition period from 1 January 2020, the key things such as the highest authority, voting rules for major issues, quorum, share transfer mechanism and dividend distribution of a joint venture will need to be changed to comply with PRC Company Law.
However, it is unclear how the shareholders of the existing joint ventures can successfully achieve the above changes as such changes may have great impact on the interests of the shareholders in the joint ventures.
We understand that implementation regulations of the FIL are already being prepared by the Chinese government forthwith the pass of the FIL on 15 March 2019. Before any implementation regulations for the FIL is issued, most of the stakeholders may adopt a wait-and-see attitude. We do not expect there will be many specific guidelines addressing how to complete these changes on corporate governance for the shareholders of the joint ventures. Both foreign and Chinese investors will have to work it out by themselves based on their shareholding, role in the joint ventures, dependency on the other party as well as their bargaining power. Foreign investors seeking to build a majority in an existing joint venture will likely need to leverage their financial strength (i.e. attractive purchase price); support for the joint venture (i.e. introduction of state of the art products); or other aspects of leverage that will vary from case to case. The truly practical solution may have to be on a case-by-case basis and the ultimate objective may only be reached through commercial negotiations.
2. share transfer
Under the JV Laws, a shareholder needs to obtain consents of all other shareholders if it intends to transfer its shares in the joint venture regardless of whether it is an internal transfer (i.e., transfer to another shareholder if there are more than two shareholders) or it is an external transfer. In contrast, PRC Company Law offers more flexible transfer mechanism – there are no consent requirement if it is an internal transfer; in case it is an external transfer, consents of more than half of the other shareholders are required and if any other shareholder refuses the transfer but refuses to buy such shares to be transferred, then such shareholder shall be deemed having agreed with the proposed transfer. The Company Law also allows the shareholders to agree on different share transfer mechanism, which gives more flexibility to shareholders on transfer of shares. While China’s Supreme Court has issued an interpretation[vi] that aimed to adopt similar share transfer mechanism of the Company Law to joint ventures, there are still many deadlocks in reality in transferring shares of joint ventures arising out of the tight share transfer requirements under the JV Laws.
3. Dividend distribution scheme
Under EJV Law, the profit distribution among shareholders must be in proportion to their respective contribution to the registered capital of the joint venture and there is no room for the shareholders to agree otherwise. While the Company Law adopts similar mechanism to the EJV Law but offers room for shareholders to have alternative distribution mechanism. Such flexibility will provide new tools to investors in profit distribution especially for those financial investors. The CJV Law actually provides very flexible dividend distribution mechanism – it allows the investors to share profit based on joint venture contract. In this sense, contractual joint ventures may be less affected by the Company Law on dividend distribution. However, contractual joint ventures account for a small amount of joint ventures in China comparing the number of equity joint ventures.
4. Foreign debt quota
The foreign debt quota for FIEs has been calculated based upon the difference of its registered capital and total investment for more than 30 years.[vii] After pilot schemes and modifications since 2016, the People’s Bank of China (PBOC) published a notice on 12 January 2017 introducing a nationwide regulation mode of all-round cross-border financing (the “Notice”)[viii]. Under this new mode, the approval procedures are more convenient and the foreign debt quota might be higher (but to be honest the calculation formula under the new mode is a bit complicated). The Notice provides a one-year transition period (which is due in early 2018) and the final regulatory mode has not been issued by PBOC and SAFE.After the effectiveness of the FIL, it is uncertain whether the concept of “total investment” will still exist and whether the foreign debt quota will still be subject to the difference between the total investment and the registered capital of an FIE or it will be replaced by the new mode introduced under the Notice.
5. Repatriation of profit
The transfer of funds offshore is still restricted but it is important to note that the Chinese authorities have not blocked legitimate repatriation of dividend payments. In recent years measures have been tightened at times but this situation may be greatly improved after the effectiveness of the FIL. According to Article 21 of the FIL, foreign investors will be free to remit such as profits, capital gains, income from asset proposal or intellectual property royalties outside of China in accordance with PRC law. We do not expect that the foreign investors can be “totally free” to remit funds in or outside of China. However, we do expect that foreign investors will enjoy more convenience when remit their profits outside of China.
6. Minimum shareholding requirement
Under JV Laws and relevant regulations, the shareholding held by a foreign investor in a joint venture shall generally not be lower than 25%.[ix] In case the shareholding of the foreign investors in a joint venture is lower than 25%, the foreign investors may not be able to enjoy tax preference treatment.[x] While tax preference treatment has been substantially dwindled since 2008 when FIEs enjoyed the same enterprise income tax as domestic companies, in practice, 25% of shareholding in some places is still treated as a threshold for foreign investors in a joint venture. After the effectiveness of the FIL, there will be no such 25% shareholding requirements in joint ventures. This will provide a more flexible mechanism to foreign investors who may enjoy minority shareholder status.
What Should Existing JVs Do Now?
The FIL will have a direct impact on existing JVs especially on their corporate governance. We believe the shareholders of the existing JVs should now start considering how to adapt the upcoming changes for their JVs and make it hopefully a win-win situation.
Below are some suggestions for the shareholders of the joint ventures in considering the prospective changes:
1. Evaluating your bargaining power and considering your core interests
The change of the corporate governance will likely be a game-changer for many joint ventures as the change may mean the increase and decrease of control power between the parties. For shareholders of a joint ventures, the first and foremost thing may be to know your position –are you the majority shareholder, minority shareholder or you are in a 50:50 position with your partner? The bargaining power and strategy may be different if you are a majority shareholder as opposed to the situation where you are a minority shareholder. In case you are the majority shareholder, you may wish to reduce the restrictions of unanimous consents and simply take the advantage of voting rights based on shareholding (particularly if you hold 2/3 or more of the shares in the joint venture). However, if you are the minority shareholder, you may wish to keep the unanimous consent mechanism offered by the JV Laws unchanged to avoid your powers be deprived or weakened. Having said that, on one hand, shareholders with more bargaining power may intend to push forward the change sooner and it may be a good opportunity for them to increase their control over the joint ventures. On the other hand, however, shareholders in a minority position with less bargaining power may need to consider how you can preserve your unanimous consent power For many joint ventures, if changes on the corporate governance is unlikely to be made in the near future, shareholders may also need to consider the possibility of buyout of the shares of the other party if needed.
2. Preparing for “old wine in new bottle”
Many shareholders of the joint ventures may resist the change of the corporate governance if they are minority shareholders or if they are in 50:50 shareholding structure with their partners, in which case, the parties may have to consider how to preserve the current corporate governance under the JV Laws in the corporate governance under the Company Law.Under the JV Laws, a minority shareholder or 50:50 shareholder actually has the veto right on Board meetings on major matters (such as change of articles of association, increase or decrease of registered capital, merger or spin-off and dissolution) based on the requirements for unanimous consent of directors attending the Board meeting under JV Laws, such arrangement can also be achieved in shareholders’ meeting by requesting 2/3 or more voting rights for the said key matters.
3. Getting prepared for dialogue with your partner
We believe the change of the corporate governance of the joint ventures will trigger a round of new negotiations between the shareholders of the joint ventures. Each shareholder of the joint ventures may need to evaluate their own position in the joint venture and get prepared for dialogue with your partner.
For the joint ventures which are still in the process of establishment and intend to close the deal before the effectiveness of the FIL, the parties may also need to dialogue with each other on the future changes on the corporate governance. To save another rounds of new negotiations, the parties may prepare additional clauses or a supplementary agreement on how to change the corporate governance according to Company Law (e.g., whether unanimous consent will be required for certain key matters) so as to ensure a smooth transition in the future.
4. Taking into account China’s further opening up on foreign investment
As stated above China has been on a long journey of foreign investment liberalization. It is likely that over the five-year transition period China’s Negative List for sectors that are prohibited or restricted to foreign investment will continue to become shorter. Recent examples in 2018 included the lifting of foreign ownership restrictions in auto manufacturing and financial institutions. Last year when the similar restrictions were loosened, Tesla immediately signed a deal to set up a wholly foreign-owned car plant in China[xi] and UBS doubled its shareholding ratio in a securities joint venture[xii].
Therefore, for certain restricted sectors, shareholders of the joint ventures should continue to monitor the advantages that may arise from China’s further relaxation on foreign investment. Investors new to China that are in the process of establishment should ensure that the contracts take advantage of future loosening of restrictions.
（1）Updates on technology transfer
On 18 March 2019, just three days after the passing of the FIL, Chinese Premier Li Keqiang executed the Decision of the State Council on Revising Certain Administrative Regulations (State Council Decision).
The State Council Decision made revisions to, amongst others, the Implementation Regulations of the EJV Law and the Administration Regulations of the Import and Export of Technology, which includes the removal of the following requirements:
- the term of technology transfer agreement for the Sino-foreign equity joint ventures normally may not exceeds 10 years;
- assignee of technology (i.e., Chinese partner) shall be entitled to continue to use such technology after the expiration of technology transfer agreement;
- within the term of technology import agreement, the results of any improvements in the technology shall belong to the party who makes such improvements; and
- technology import agreement shall not include certain restrictions, such as clauses requiring that the assignee must accept incidental conditions that are not essential to the import of technology.
This State Council Decision is in line with the principle of the FIL and to some extent shows the Chinese government’s determination to address the concerns of foreign investors with regard to forced technology transfer.
（2）Implementation regulations and further opening up
According to Premier Li Keqiang’s speech at the 2019 BoAo Forum, China has already started the draft of implementation regulations of the FIL and expect to issue such implementation rules by the end of this year and with the aim that the implementation rules to take effect at the same time as the FIL on 1 January 2020.
Premier Li Keqiang also revealed that China will further loosen foreign investment’s market entry into China. A new and shorter Negative List is expected to be issued this June 2019. In addition, China will expand the opening up in certain sensitive areas such as value added telecom services, medical institution, education and transportation.
The FIL is more than China’s response to a looming trade war coupled with slowbalization (i.e. a retreat from globalization). In a world that is increasingly erecting barriers the FIL is a welcome message from the Chinese government that China is open for business. After almost 40 years of China’s reform it signals China as a, perhaps unlikely, champion of trade and investment liberalization.
- It is no doubt that the FIL will reshape the Chinese foreign investment legal regime and will formulate the new landscape of China’s foreign investment in the long run. The keenest and most immediate impact FIL will not be felt by those watching from afar or considering entering the Chinese market. While for the nearly 300,000 China’s FIEs especially the existing joint ventures, their shareholders will have the opportunity to restructure the management and corporate governance of their joint ventures in a far more flexible fashion. We believe such changes may not be achieved overnight and both the Chinese and foreign shareholders will need to weigh in their bargain power, interdependency and core interest when striking a deal.