The Ministry of Commerce ("MOFCOM") of the People's Republic of China1 ("China" or "PRC") issued a draft of the Foreign Investment Law (the "Draft Law") for public comment on 19 January 2015. The deadline for the public to submit comments is 17 February 2015. The Draft Law is accompanied by an announcement also dated 19 January 2015 (the "Draft Law Announcement") which outlines some of the reasoning and principles applied by MOFCOM in preparing the Draft Law. If enacted as currently drafted, the Draft Law will have farreaching implications for foreign investment into China. On a very simple level, the Draft Law promises to unify China's current legal regime on inbound foreign investment ("FDI"), which consists of the Wholly Foreign-Owned Enterprise Law (the "WFOE Law"), the Sino-Foreign Equity Joint Venture Law (the "EJV Law"), the Sino-Foreign Contractual Joint Venture Law (the "CJV Law"), their respective implementing rules, and applicable provisions scattered throughout numerous other laws, regulations2 and departmental rules. How much of the surrounding legislation will be kept remains to be seen, but the Draft Law imposes a three year transitional period during which existing foreign invested enterprises ("FIEs") will need to align themselves with, amongst others, the Company Law (the "Company Law"), suggesting a move towards applying the same rules as those applied to domestic capital companies. The Draft Law contains quite a few innovations and breakthroughs, some of which promise to help ease FDI restrictions. However in many respects, the Draft Law also imposes new and onerous obligations on foreign investors, particularly in terms of information disclosure. In this note, we analyse some of the new features that may have a substantial impact on existing or future FDI projects. 1 In this note, references to China exclude its Hong Kong Special Administrative Region, Macau Special Administrative Region and Taiwan. 2 These other laws, regulations and rules include the Company Law, the Securities Law, the Partnership Enterprise Law, the Acquisition of Enterprises in China by Foreign Investors Provisions, the Circular on Launching the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, Changes to the Equity Interests of Investors in Foreign-Invested Enterprises several Provisions, Investments Made by Foreign-Invested Enterprises in China Tentative Provisions, Foreign Investors' Strategic Investments in Listed Companies Administrative Measures, among others. EXECUTIVE SUMMARY In brief, the Draft Law: • Takes a new approach to the definition of Foreign Investment and Foreign Investors, which may have a substantial impact on variable interest entities ("VIEs"), and which exposes the offshore activities of foreign investors relating to China to a much greater level of scrutiny than before. • Expands the definition of regulated types of foreign investment beyond equity shareholding to include longterm financing and contractual controls, among others. • Replaces the current mandatory MOFCOM approval system for the establishment of any FIE with a "market entry permit ("Market Entry Permit") system" which will only be required for companies that will operate in a "restricted" sector, thereby streamlining and simplifying the establishing process for FIEs that are not operating in restricted or prohibited sectors. • Adopts a "Negative List" approach listing only restricted and prohibited sectors to replace the current Guidance Catalogue for Foreign Investment Industries3 , an approach modelled on the system in place in the China (Shanghai) Free Trade Zone ("FTZ"). • Authorizes MOFCOM, for the first time, to attach restrictive conditions to its approvals (Market Entry Permits). • Adopts a reporting mechanism to replace MOFCOM approvals for post-establishment changes in equity interests and so forth, thereby eliminating investor uncertainty from certain transactions currently subject to discretionary MOFCOM approvals. • Substantially increases the reporting burden on FIEs through this same reporting mechanism, and raises concerns about the publication of sensitive business 3 The latest version of which promulgated by the National Development and Reform Commission and MOFCOM and took effect on 30 January 2012, but a new version is currently being drafted. This divides foreign investment industries into three main categories, those that are "encouraged", "restricted or "prohibited" vis-a-vis foreign investment. Those sectors not listed in the Guidance Catalogue by default fall into a fourth, residual category of "permitted" for foreign investment.2 information that could be valuable to competitors of FIEs. • Expands the scope of potential national security review, eliminating the previous approach, which was limited by transaction type and sector. • Appears to forbid a broad swath of VIE participation in prohibited sectors (unfortunately, without any indication that these sectors will otherwise ever be liberalised, and therefore likely stymying development and growth in this area). • Lays out various administrative (and even criminal) sanctions for non-compliance with the new law, including stiff penalties for failure to comply with the new reporting obligations. • Establishes a new mechanism for foreign investors to make complaints to a third party agency about any mistreatment by any relevant government departments. Each of these, and other key issues, are analysed in greater detail below. DEFINITION OF FOREIGN INVESTOR The Draft Law classifies persons or entities as either foreign investors ("Foreign Investors") or Chinese investors ("Chinese Investors"). Previously, under, for example the EJV Law, the preamble in Article 1 simply referred to "foreign companies, enterprises, other economic organisation or individuals" (emphasis added) as "foreign parties", and permitted them to enter into an equity joint venture (an "EJV") with "Chinese investors" comprising "Chinese companies, enterprises or other economic organisations", thereby prohibiting Chinese individual citizens from entering into an EJV with "foreign parties" whilst allowing foreign individuals to form EJVs with Chinese investors. This anachronistic prohibition has clearly been dropped in the Draft Law. Under the Draft Law, there are specific definitions of Foreign Investors and Chinese Investors. Foreign Investors are defined as: (a) non-Chinese nationals i.e. foreign passport holders4 ; 4 Article 159 of the Draft Law makes it clear that Chinese nationals who have obtained foreign citizenship (which, incidentally is unlawful under the Nationality Law which does not permit dual nationality) will be considered as foreign investors, regardless of whether the investment took place before or after the Foreign Investment Law comes into force. This will give rise to issues where a domestic individual (or group of individual shareholders) has subsequently acquired a foreign passport, especially if it changes the nature of the underlying investment from being Chinese controlled to foreign controlled (see the section on VIE structures below). Articles 160 and 161 (b) entities incorporated outside China; (c) foreign governments or their agencies; and (d) international institutions. Chinese Investors are defined as: (a) Chinese nationals; (b) the Chinese government or its agencies; (c) Chinese Enterprises controlled by the aforesaid (a) and (b). An enterprise established in China (a "Chinese Enterprise"), but controlled by Foreign Investors (a "Foreign-controlled FIE"), is now explicitly to be treated as a Foreign Investor, whereas a Chinese Enterprise that on its face is foreign-owned but is actually controlled by Chinese Investors shall be treated as a Chinese Investor (a "Chinese-controlled FIE"). This may have a far-reaching impact on VIEs in China and marks the first time that a "control" concept has been introduced into Chinese FDI law. Under a VIE structure, the offshore entities control the domestic operating entity (and possibly a host of others controlled by it) through an onshore Wholly Foreign-Owned Enterprise ("WFOE") by means of entering into various agreements with the domestic capital enterprise that holds the various permits and licenses needed to operate the underlying business, typically including an Exclusive Technology Service Agreement, Equity Pledge Agreement and others. We have analysed the potential impact of the Draft Law on VIEs in a separate section below. DEFINITION OF FOREIGN INVESTMENT The Draft Law lists seven activities which are deemed to constitute foreign investment: (a) establishing new enterprises in China (i.e. greenfield investments which have been traditionally captured under the term FDI); (b) acquiring shares, equity interests, shares of assets, voting rights or other similar rights in existing Chinese Enterprises (i.e. various forms of M&A); suggest that special rules will be promulgated in future covering US green card holders or holders of other forms of permanent residence overseas, and, conversely, for foreigners' holding Chinese permanent residency rights. The Draft Law is silent on the nature and content of such "special treatments".3 (c) providing financing with a term of more than one year to a Chinese Enterprise stated in the aforesaid item (b); (d) obtaining concessions to explore or develop China's natural resources or construct or operate infrastructure projects; (e) acquiring land use rights or property owning rights; (f) gaining control over or otherwise holding interests, in a Chinese Enterprise through contract, trust or other structures; and (g) carrying out an offshore transaction if the said transaction causes a Foreign Investor to gain control over a Chinese Enterprise. This list represents a substantial expansion of what has until now been considered to be foreign investment and thus subject to Chinese FDI laws, in particular by the inclusion of items (c), (e), (f) and (g). It points to a worrying tendency on behalf of MOFCOM to start regulating for the first time purely offshore transactions5 , where Foreign Investors gain control over Chinese Enterprises, a point that is reiterated in the new and highly onerous information disclosure provisions discussed below and under the guise of imposing a requirement to disclose the "actual controller". It also means that for real estate development projects where you must, by law, obtain land use rights prior to establishing a company to develop them6 you effectively become subject to the information disclosure rules before you have established a legal presence in China. MARKET ENTRY PERMIT SYSTEM TO REPLACE APPROVAL The Draft Law replaces the approval regime currently applicable to WFOEs, EJVs, and Cooperative Joint Ventures ("CJVs"), known collectively as FIEs with a new "[market] entry permit" regime. The key differences between establishing a domestic capital company and an FIE under the current legal regime are that: (a) Foreign Investors must comply with, and are subject to, the restrictions imposed by, and the categorisation under, the Guidance Catalogue. This, in turn, determines the approval procedures 5 Previously the only approvals relating to pure offshore transactions were the requirement to make a merger control filing with MOFCOM if the turnover thresholds were met and a Circular 698 tax filing if the criteria were met, but MOFCOM did not otherwise have visibility to offshore transactions. 6 MOFCOM and State Administration of Foreign Exchange ("SAFE") Circular on the Strengthening and Standardisation of Approvals and Regulation of Foreign Direct Investment in Real Estate issued on 23 May 2007. and thresholds applicable to the new establishment of any FIEs, or M&A activities. (b) in principle, under the Administrative Measures on the Approval and Record-filing of Foreign Investment Projects issued by the National Development Reform Commission ("NDRC") effective 17 June 2014 ("New NDRC Procedures") as amended by the Decision of the NDRC on Amending Certain Provisions of the Administrative Measures on the Approval and Record Filing of Overseas Investment Projects and the Administrative Measures on the Approval and Record-filing of Foreign Investment Projects effective 27 December 2014 ("Amendment Decision"), all foreign investment projects are subject to NDRC record-filing or approval, depending on whether or not they meet certain parameters, whereas domestic capital investment projects only trigger an approval if the law so requires or the project is a type listed in Catalogue of Investment Projects subject to Government Approval (2014 Version) issued by the State Council effective 31 October 2014 ("Approval Catalogue"). (c) MOFCOM approval is required in principle for all foreign investment projects large or small (except in the FTZ and in certain financial sector industries, where the approval authorities are the corresponding industry regulators)7 . (d) the only common point with domestic investors is that FIEs have to be registered with their local Administrations of Industry and Commerce ("AIC") which issue their business licences. NEW MARKET ENTRY PERMIT SYSTEM TO REPLACE APPROVALS Under the Draft Law, a Foreign Investor must obtain a Market Entry Permit before operating if: (a) it is to operate in a restricted sector on the "negative list" (see below); and/or (b) its investment amount exceeds a certain threshold (the "Investment Amount Approval Threshold"). 7 In Article 166 of the Draft Law, the financial sector industries like banking, insurance, securities and other financial sectors are subject to approval and ongoing supervision by the relevant industry regulators, so the China Banking Regulating Commission for banks, the China Insurance Regulatory Commission for insurance and so forth.4 This may give rise to some anomalies where a large scale investment in an unrestricted sector needs to obtain a Market Entry Permit due to its size alone. Under the Draft Law, one of the most fundamental changes to the way foreign investment is regulated is the adoption of a 'negative list' approach under the document entitled the Special Administrative Measures Catalogue ("Negative List"). This will replace the current scheme under the Guidance Catalogue. In contrast to the Guidance Catalogue approach, where industry sectors are classified under the "encouraged", "restricted", and "prohibited" categories, with unlisted industries considered by default to fall into the "permitted" category, the Negative List will only list restricted and prohibited sectors, and any sectors not on the list will not be subject to a formal Market Entry Permit process. There has not yet been a draft Negative List issued, but it is expected to be issued at the time the Draft Law becomes effective. The real breakthrough is that this means that in sectors which are not on the Negative List and for investment amounts below the Investment Amount Approval Threshold, only registration with the relevant AIC will be required. To this extent it represents a true level playing field with domestic investors. The Negative List will be divided into two sub-catalogues: the Restricted Sectors Sub-Catalogue and the Prohibited Sectors Sub-Catalogue. A Foreign Investor may not invest in any sector listed in the Prohibited Sectors Sub-Catalogue (a "Prohibited Sector"), and a Foreign Investor may only invest in a sector listed in the Restricted Sectors SubCatalogue (a "Restricted Sector") upon obtaining a Market Entry Permit. Additionally, a Foreign Investor will need to obtain a Market Entry Permit, regardless of its sector of operation, if its investment amount exceeds the Investment Amount Approval Threshold set by the State Council in the Restricted Sectors Sub-Catalogue. Multiple investments made by a Foreign Investor in relation to the same project will be aggregated when deciding whether the investment amount of a specific project exceeds the Investment Amount Approval Threshold, in a bid to head off artificially dividing up a project into phases or parts to avoid approval. This is a tactic which has long since been outlawed by MOFCOM when it was used by investors to divert approvals down to the local MOFCOM level. Furthermore, loans with a term of more than one year provided by the Foreign Investor will also count towards the investment amount as well. The Draft Law Announcement does not describe what the Investment Amount Approval Threshold will be, but in order for this to make sense and not undermine the whole concept of simplifying the regime, it would have to be set at a very high level. It is notable that there is no mention anywhere in the Draft Law of "total investment amount". China pins investment approval thresholds under the current approval regime for FDI inbound investments to total investment amount, which can best be understood as committed equity plus permitted levels of debt, based on debt-equity ratios prescribed by law. It is intriguing to speculate as to whether this means that the debt-equity ratios applicable to FIEs in place since 1987 (slightly different rules apply in the FTZ) which have to date proved a largely insurmountable barrier to leveraged acquisitions may be dropped. It would be unusual for no mention of the concept to be made in the Draft Law while retaining the existing restrictions, but that possibility cannot be ruled out. MARKET ENTRY PERMIT REVIEW PROCESS Under the Draft Law, the Market Entry Permit review process will be focused on the Foreign Investor, the actual controller, and impact of their investments on national security, energy, resources, technological innovation, the environment, job opportunities in China and so forth. Conceptually these factors may also be included as part of MOFCOM (or NDRC's) overall review under the current approval regime, but in practice MOFCOM review at the local level has often largely focused on the substance of certain transactional documents, especially joint venture contracts, articles of association, and equity interest/asset purchase agreements (collectively, "Transaction Documents"). The Draft Law Announcement indicates that there is a clear change of focus with the Draft Law, eliminating, or at least turning the focus away from, reviewing the Transaction Documents and placing it squarely at the "macro" level. It will be interesting to see whether this puts MOFCOM on yet another collision course with NDRC. It is well known that MOFCOM and NDRC have, for many years, been engaged in what can only be described as a "turf war" for control over the approval of FIEs. A similar collision course is set with outbound investments by Chinese companies where NDRC and MOFCOM's approval remits have largely coalesced into overlapping approvals for investment in sensitive countries, regions or industries, where they both apply different definition of "sensitive". In the past, it was possible to distinguish MOFCOM and NDRC's roles on the basis that MOFCOM was more "micro" looking at the Transaction Documents and NDRC more "macro", but going forward, this will no longer be the case. Again, the silences in the Draft Law speak louder than the words: no mention is made of NDRC approval anywhere in the Draft Law. The only elliptical reference is in Article 21 which states that: "The departments in charge of foreign investment (i.e. MOFCOM at various levels) will implement foreign investment market access, in conjunction with the [other] relevant departments in charge". This could simply be a reference to MOFCOM working with industry-specific regulators rather than NDRC. It is not clear whether a separate parallel NDRC approval process for FDI will be maintained, but it does seem surprising that nowhere is it touched upon if this is to be the5 "all singing, all dancing, all-in-one" foreign investment law it purports to be. This does not mean that the FIE Transaction Documents will not still be subject to extensive review following the Draft Law, for the key documents may still have to be submitted to the AIC upon registration, but it does suggest that Transaction Document review will be a lesser part of Market Entry Permit review by MOFCOM going forward. CONDITIONS TO MARKET ENTRY PERMITS The Draft Law authorizes MOFCOM to attach restrictive conditions when granting Market Entry Permits, as follows: (a) to spin-off of certain assets or business; (b) shareholding ratio restrictions; (c) operating term requirements; (d) investment region restrictions; and (e) local employment percentage quotas or quotas, with of course the 'sweep-up' provision of "other restrictions stipulated by the State Council" that allows the State Council to impose other restrictions from time to time with no visibility to Foreign Investors as to what these may be. Foreign Investors will be required to comply with each such condition so imposed. This totally new concept is a major concern for Foreign Investors because: (a) it is not transparent in terms of the impact and is untested waters – under the existing FDI regime there are no such conditional approvals: under the Draft Law the only criteria for imposing such conditions is that MOFCOM decides to do so after an investigation, suggesting a pure discretionary regime which could be impacted by lobbying by domestic competitors, protectionism and other opaque factors; (b) it is not clear why such restrictive conditions are needed outside the anti-trust or national security regime; interestingly the former is only briefly touched upon in the Draft Law where in the submission documents to MOFCOM the foreign investor must provide an "explanation" on the antimonopoly investigation status, whereas the latter seems to be completely integrated (albeit in an amended form) into the Draft Law (see section below); this suggests a separate anti-trust regime will be maintained, presumably because MOFCOM is only one of a triumvirate of regulators under the antitrust regime (the others are NDRC and the State Administration of Industry and Commerce ("SAIC")), whereas it plays the role of sole coordinator under the national security review regime; and (c) it raises a World Trade Organisation ("WTO") commitment compliance issue – presumably China could not use a shareholding percentage restriction or other restrictions to impose restrictions beyond those China agreed to at the time of its WTO accession in 2001? INDUSTRY-SPECIFIC APPROVALS The Draft Law clarifies the relationship between Market Entry Permits and industry approvals. If the investment requires pre-approval by industry regulators, the Foreign Investor should obtain that pre-approval before applying to MOFCOM for a Market Entry Permit. If the investment requires approval by an industry regulator but the applicable law allows that approval to be obtained after the Market Entry Permit is granted, MOFCOM should seek written opinions (as opposed to the actual approval) from the industry regulator before granting a Market Entry Permit. REPORTING MECHANISM TO REPLACE OTHER MOFCOM APPROVALS In addition to replacing MOFCOM approval with a Market Entry Permit regime for FIE establishment, the Draft Law also replaces various post-establishment approvals with a comprehensive reporting mechanism. Currently, an existing FIE must obtain MOFCOM approval when it undergoes certain fundamental corporate changes, including: (a) the transfer or pledge of equity interests; (b) amendment to its articles of association; (c) amendment to a joint venture contract (EJVs/CJVs only); (d) capital increases; (e) capital reductions; and (f) liquidation. Under the Draft Law, these approvals will no longer be required. Instead, FIEs and Foreign Investors will be subject to a comprehensive and on-going reporting obligation with the competent MOFCOM, that not only covers corporate changes previously requiring approval, but also a post-establishment implementation report and an annual report.6 ONEROUS REPORTING REQUIREMENTS AND THEIR POSSIBLE IMPACT ON FOREIGN INVESTMENT More specifically, three types of information reports will be required to be filed with the competent MOFCOM: (i) Reports on Implementation of Foreign Investment (the "Implementation Report"). A Foreign Investor or FIE should submit this report before, or within 30 days after, the implementation of a subject foreign investment. This report should include the basic information of the Foreign Investor, the foreign investment and the FIE, including certain sensitive information (e.g., actual controller and source of capital). (ii) Reports on Changes to Foreign Investment. A Foreign Investor or FIE should submit such a report within 30 days after one of a list of specified changes occurs. If any change triggers any new Market Entry Permit requirement e.g. the investment on a capital increase exceeds the Investment Amount Approval Threshold, the Foreign Investor must apply to the competent MOFCOM for a new Market Entry Permit. (iii) Periodic Reports (the "Periodic Reports"). Each year a Foreign Investor or FIE should submit an annual report by April 30. This reporting obligation applies to all Foreign Investors and FIEs. An FIE controlled by Foreign Investors and meeting either of the following thresholds should submit quarterly reports within 30 days after each quarter: (a) its total assets or sales revenue exceeds RMB 10 billion or (b) it has more than 10 subsidiaries in China. While the removal of the approval procedures for changes to FIEs is generally welcomed by Foreign Investors, we have concerns that the information required in the new reporting regime is too broad and requires certain sensitive information (e.g., actual controller and source of capital, particularly for fund investors who typically do not like to reveal information on their LPs) that may frighten potential investors away. Whilst it is not entirely clear, Article 76 of the Draft Law suggests that MOFCOM will be establishing a foreign investor database (外国投资信息报告系统) available for public inquiries (except for trade secrets and personal data) which appears to be in addition to the nationwide enterprise creditworthiness database currently in place, which, in principle, lists certain data on all enterprises nationwide ("Current Database"). The Current Database is maintained by SAIC and available for public searches. The Draft Law is silent on the relationship between the foreign investor database and the Current Database and on whether MOFCOM would have discretion to restrict access or reject an inquirer's inquiries about any data on the foreign investor database. As noted above, all those who are classified as Foreign Investors (including real estate investors who have yet to establish an entity in China) are under an obligation to file the suite of reports listed above. It is arguable whether in this case the "cure" (removing approval requirements but replacing them by onerous disclosure requirements) is not in fact worse than the "illness". Let us take one example: when a foreign investor sets up in China, the last thing it wants is to be compelled to tell all its domestic or foreign competitors all about its proposed activities. If the information provided to MOFCOM is publicly searchable on the database, that is precisely what the Implementation Report will do. It must contain at least the following information: (a) basic details on the foreign investor including name, address, place of registration, actual controller, organisational form, main business activities, contact person and details; (b) basic details on the foreign investment, including the investment amount, the source of funds, areas of investment, regions of investment, timing for investments, method of investment, capital contribution percentage and form of capital contribution, and status of having obtained relevant administrative licenses or record filings; and (c) basic details on the FIE, including name, address, organisational code number, registered address, shareholding structure, investment amount, registered capital, actual controller, organisational form, business scope, contact person and details. A reduced list of (a) and (b) is imposed on those Foreign Investors whose cases do not involve establishing or making changes to an FIE. This would appear to be something of a 'gift' to the FIE's competitors in China, and will allow them to plan a counterstrategy and take measures before the FIE has had a chance to get started in business. There is also, in Article 86 of the Draft Law, a requirement to update within 30 days of implementing any investment any changes to the information provided prior to making any investment. Query whether this means reporting offshore changes as well – the suggestion being that now actual offshore controller changes are reportable. Other examples of onerous disclosure obligations abound in the Draft Law: these go significantly beyond those imposed on purely unlisted domestic capital enterprises which at law currently only have the following information disclosure obligations: (a) basic details on the subject domestic capital enterprise including name, registered address, name7 of the legal representative, registered capital, organisational form, business scope, operating term; (b) basic information on shareholders including basic identity information of each individual shareholder (e.g., a copy of her or his identification card) and business license information of each corporate shareholder; (c) identity information of each director, supervisor and general manager (e.g., a copy of her or his identification card, current home address, title, term of office, by whom she or he is appointed); (d) contact person and details. It can be seen from the above that in terms of information disclosure obligations, China is clearly not applying national treatment to Foreign Investors. One of the most worrying provisions in the Draft Law is Article 94, which imposes listed company type quarterly Periodic Reports on foreign-controlled unlisted groups with over 1 billion RMB in turnover or over 10 subsidiaries in China (not further defined). In other words, most large MNCs in China. Article 95 goes on to say that the FIE is responsible for consolidating all the information needed from directly or indirectly controlled subsidiaries and submitting on their behalf, which may constitute a huge burden. This adds a new cost to unlisted FIE groups that gives them a competitive disadvantage compared to their domestic peers. To add further fuel to the fire of foreign investor concern, while investing in Prohibited Sectors or Restricted Sectors without a Market Entry Permit only gives rise to a fine on the face of the Draft Law (although presumably the criminal offence of unlawful operations (非法经营) under Article 225 of the Criminal Law (the "Criminal Law") remains a possibility in such cases), conversely under Article 148 of the Draft Law. (a) evading information disclosure obligations; (b) concealing information as to the true circumstances during information disclosure reporting; or (c) providing misleading or false information in violation of the law, can, in particularly serious circumstances, lead to the FIE being fined and the directly responsible officers in charge being given a prison term or administrative detention of up to one year, suggesting a new criminal offence will need to be created for this. This will require an amendment to the Criminal Law. One final point on information disclosure is the fact that the Draft Law makes provisions which appear to overlap with, or cut across current China Securities Regulatory Commission ("CSRC") provisions on disclosure of interests. For example, under the current law, namely the Acquisitions of Listed Companies Administrative Procedures (the "Takeover Rules") promulgated by CSRC, where as a result of trading on a stock exchange the shares or interests held by an investor and any persons acting in concert with it reaches 5% of the issued shares in a listed company, the investor and its "concert parties" are under an obligation to file a comprehensive report with CSRC within 3 days of the event occurring. It is difficult to see what purpose lies behind (amongst others) Article 93 of the Draft Law, which requires a Foreign Investor who buys less than 10% of the shares in a listed company and has not given rise to a change in controller of the listed company to report on the same before 30 April every year, given that such information will already be out of date by then and should already have long been disclosed to the market once it reaches the 5% threshold. It suggests a lack of coordination between CSRC and MOFCOM for disclosure under the Takeover Rules and that CSRC is not systematically transmitting such reports to MOFCOM. This seems like a clear example of overlapping regulation without any obvious regulatory purpose. NATIONAL SECURITY REVIEW The Draft Law contains a section on national security review which is designed to strengthen China's mechanism for national security review of foreign investments. The Draft Law section is built on the basis of the current regime, described in the Office of the State Council's Notice on the Establishment of the Security Review System for Foreign Mergers and Acquisitions of Domestic Enterprises, but with a number of significant changes thereto. In particular, Foreign Investors will want to take note that the Draft Law: (a) Significantly expands the scope of matters which are subject to national security review. Under the Draft Law, any foreign investment which jeopardises or may jeopardise China's national security will require national security review, regardless of the sector, transaction type or control rights. This approach stands in contrast to the current regime, which is specific to certain sectors and transactions types. 8 ; 8 Currently, security review is mainly required by certain mergers and acquisitions. The scope of M&A security review covers: M&A activities by foreign investors involving military industrial enterprises or military industry related supporting enterprises, enterprises located near key and sensitive military facilities, and other entities relating to national defense; M&A activities by foreign investors involving key domestic enterprises in sectors such as agriculture, energy and resources, infrastructure, transportation, technology, assembly manufacturing, and so forth, whereby foreign investors might acquire actual control over such enterprises.8 (b) Introduces an advance consultation mechanism for clarifying national security review procedures. We regard this as a positive development, and it may be of great value if it turns out to able to give substantial guidance with some reference to a preliminary set of facts, including what issues they might raise, the agency's current attitude and policy towards them, and any particular procedures or documents that might be required; (c) Makes decisions made in national security review cases immune from both administrative review and administrative litigation. While this sounds quite prohibitive at first blush, precedence for such immunity can be found in the legislation of other countries, including in US CFIUS review, and in practice, this provision in the Draft Law may not be of great practical significance to Foreign Investors in China, where few if any ever formally challenge examination and review agency decisions, let alone those touching upon national security. Among these and other changes, the biggest concern for investors will likely be the broadened scope of matters subject to national security review, as hypothetically, any foreign investment could potentially fall under such scope. This may give rise to considerable uncertainty in foreign investment projects, which may be exacerbated if the process is not implemented in an objective and transparent way. In this sense, the new rules on national security review may hurt more than help the general legislative goal of creating a more attractive foreign investment environment. IMPACT ON VIE STRUCTURES The Draft Law, if enacted in its current form, will be the first Chinese law to expressly address the legal status of VIEs. For a more detailed explanation of VIEs, please refer to our Client Note "China VIE structure for foreign investment under attack from multiple directions: Will it emerge (relatively) unscathed or is its very survival threatened?" dated September 2012. In China, VIEs are typically (but not necessarily) used by companies that wish to attract foreign investment or go public overseas but operate in sectors that are "restricted" (or even "prohibited") to foreign investment under the Guidance Catalogue or to circumvent the restrictions on "round tripping" investments. For more than a decade, the Chinese government has turned a blind eye to VIEs, providing few if any official statements, let alone any legislation, approving, denying, or even acknowledging the existence of such a structure. Because of this, many VIEs, particularly in the technology, media and telecommunications sectors, have been operating in a grey area of the law. That said, recent decisions made by China International Economic and Trade Arbitration Commission in particular suggest the structure is becoming increasingly under fire and vulnerable to regulatory and legal challenge. The Draft Law appears to be the first attempt to regulate VIEs. The Draft Law proposes to eliminate the grey area by introducing the concept of control into FDI law. In the Draft Law, "Control" is defined very broadly to include control through equity holdings, voting rights, rights to appoint board members, trusts, contract, and so forth9 . Control through contract is the typical approach used by VIEs. Under the Draft Law and the Draft Law Announcement, the nature of the entity who "controls" a Chinese Enterprise (i.e., whether it is a Chinese Investor or a Foreign Investor) will determine what sectors such Chinese Enterprise may engage in, and whether a Market Entry Permit/information disclosure is required. On the one hand, a Chinese Enterprise which is determined as being controlled by Chinese Investors will be treated as a Chinese Investor (i.e. a Chinese-controlled FIE). As such, the Chinese-controlled FIE: (i) will not be subject to the FIE information disclosure obligations discussed above; and (ii) can be treated as a Chinese Investor in terms of its investment in a Restricted Sector. This leaves some scope for VIE arrangements to still be deployed for minority foreign investments where the Chinese founders retain ultimate actual control of the Chinese Enterprise. Nevertheless, the Draft Law also provides that neither a Foreign Investor, nor a Chinese Enterprise in which a Foreign Investor holds any shares, equity, asset shares, or any other interest or voting rights, will be able to invest in a Prohibited Sector. An enterprise incorporated outside China is generally considered as a Foreign Investor (except that it can be treated as a Chinese Investor in terms of its investment in a Restricted Sector if determined by MOFCOM to be controlled by Chinese Investors). No provisions under the Draft Law authorize MOFCOM to treat Chinese-controlled FIEs as Chinese Investors in terms of operations or investment in Prohibited Sectors. As such, we are of the view that, under the Draft Law, new FIEs using the VIE structure (whether Chinese-controlled FIEs or Foreign-controlled FIEs) will probably be unable to invest in any Prohibited Sector. This will have a major impact on 9 Under the Draft Law, "control" can be exercised by an investor through (i) holding more than 50% equity interest or voting rights, (ii) rights to appoint more than half of the board members, (iii) decisive influence on board resolutions or shareholders' resolutions, or (iv) contractual arrangements or trusts in place to impose decisive influence on operations, financial matters, technology, employment, etc., in or of an enterprise.9 investments in certain media sectors for example. Although MOFCOM has proposed in the Draft Law Announcement three approaches to determine the legal status of FIEs under VIE structures in Restricted or Prohibited Sectors, those approaches seem to address existing VIEs rather than new VIEs. By contrast, a Chinese Enterprise determined as being a Foreign-controlled FIE will be treated as a Foreign Investor for regulatory purposes under the new law. A Chinese Enterprise treated as a Foreign-controlled FIE: (i) may not engage in a Restricted Sector without a Market Entry Permit. (ii) may not engage in any Prohibited Sector, if a Foreign Investor holds any of its shares, equity, asset shares, or any other interest or voting rights, whether or not resulting in its obtaining control over the Chinese Enterprise; and (iii) may not make any downstream investments in any Prohibited Sector either, unless the State Council allows otherwise. These provisions of the Draft Law pose a serious question over the future of VIEs currently operating in a Restricted Sector or Prohibited Sector or both (which is the vast majority10). Given the importance and size of companies that have employed VIE structures for the purpose of an overseas listing or to allow investments by foreign private equity firms or strategic investors (Sina, Sohu, Tencent, Baidu, Alibaba to name but a few), it is likely that a grandfathering regime or transitional arrangements will need to be adopted. However we believe that it would need to be a case-by-case approach, as specific governance structures may allow for Chinese control to be established even where less than 50% of the equity is in Chinese hands, such as through different classes of voting shares with different rights, weighted voting systems permitted under many common law jurisdictions and so forth. An important market competition issue will arise if some of the dominant players in the Chinese Internet market are "grandfathered VIEs", yet other new entrants will not be able to use the structure they were able to use to gain market access. The critical question on how to address existing VIE structures is extremely difficult to resolve, given the important role that these tech giants assume in China's economy today as well as their sheer size. It is a very different and more complex issue as compared to the unwinding of the pre-cursor cousins of the VIEs, the 10 Many VIEs will have a mixed business model comprising businesses which are in Restricted Sectors and in Prohibited Sectors e.g. an ICP type business (restricted category under the Guidance Catalogue) with a Video-on-Demand business (prohibited category under the Guidance Catalogue). Chinese-Chinese-Foreign structures which were declared to be irregular and ordered unwound in the late 1990s. The innovative products which they have brought to the consumer market have been rightly applauded, but the flip side is there are a very large number of VIE structures in existence, the sums involved are huge and hence the stakes high. What is different now is that a whole new class of Chinese entrepreneurs has emerged and their interests may be adversely affected by any ill-considered intervention. Ultimately the "elephant in the room" is the need to liberalise market access in the underlying sectors, which would remove the need for many VIEs. We have seen some limited telecoms industry liberalisation in the FTZ11, but many media and other sensitive sectors remain firmly offlimits to foreign investment. The Draft Law Announcement mentions that public opinion will be considered in determining a way to resolve the uncertainties surrounding VIE structures – which can be read as tacit acknowledgement by MOFCOM of the importance of the role these companies play in the market today. As such, we are concerned that valuations of existing offshore-listed VIE companies will be affected because the transfer of shares offshore by Chinese Investors will become subject to regulation under the Draft Law, assuming it is enacted in the current form, and that private VIE companies may also be affected because certain typical provisions in VIE documents will become subject to, and even become unenforceable under, the new law. This means that: (i) As discussed above, it is very likely that companies will not be allowed to invest in any Prohibited Sector under any new VIE structures. (ii) For an offshore-listed company adopting a VIE structure, it may be difficult to ascertain who controls it in the light of the public float requirements and the public trading of its shares, unless the company's governance structure gives control to a Chinese Investor by other means recognised within the new rules. If one or more Foreign Investors were to gain control over it at any point of time (e.g. through a takeover bid), it would flip over and become a deemed Foreign Investor and would then immediately have to stop operating 11 Please refer to our Client Notes: New Rules Provide a Framework for Shanghai FTZ to Open the Doors on VATS: A Cause for Optimism? FTZ shows its hand on telecoms opening up – could this be the long-awaited breakthrough in VATS? China (Shanghai) Pilot Free Trade Zone – China’s Springboard to a Free Market?10 in Restricted Sectors requiring a Market Entry Permit (unless it can obtain a Market Entry Permit); otherwise, it will commit a severe violation under the Draft Law. This uncertainty may frighten investors away and cut off the source of desperately needed expertise and growth capital for Chinese start-ups where VIEs have been most prevalent. If China changes the law in the manner set out in the Draft Law, some overseas stock exchanges may issue new listing rules to shut the door to VIE companies which operate in Prohibited Sectors (or Restricted Sectors without Market Entry Permits)12 . (iii) It will become quite difficult, if not impossible, for Chinese-controlled private VIE companies to attract foreign investment if those companies operate in Prohibited Sectors (and/or Restricted Sectors without Market Entry Permits). What is clear from the Draft Law is that China is going to tackle the VIE issue sooner or later. The Draft Law includes a placeholder for a clause on the legal status of existing VIEs in Restricted or Prohibited Sectors. When the EU Chamber of Commerce met MOFCOM representatives recently, they reportedly indicated no decision had been made on how to deal with pre-existing VIEs. In the Draft Law Announcement, MOFCOM proposed three different approaches for public comment on how to deal with existing VIEs: (i) If an FIE that implements contractual controls reports to MOFCOM that such FIE is a Chinesecontrolled FIE, the VIE structure can stay unchanged. This approach would not give MOFCOM any discretion; (ii) An FIE that implements contractual controls should apply to MOFCOM for verification of whether it is a Chinese-controlled FIE, upon verification by MOFCOM that it is, the VIE structure can stay unchanged; or (iii) An FIE that implements contractual controls which should apply to MOFCOM for a Market Entry Permit, and MOFCOM will consider all relevant factors (including, without limitation, who controls the FIE) before approving or disapproving the 12 It should be noted that the whole point of a VIE which typically operates through a WFOE is to operate in sectors where a Market Entry Permit (typically a telecoms business operating permit from the Ministry of Industry and Information Technology ("MIIT")) is required without obtaining that Market Entry Permit in the name of the WFOE (as only domestic entities are able to obtain the relevant permit or there are joint venture or other restrictions on obtaining such a permit), so query how any WFOE outside the FTZ where 100% foreign ownership in certain telecoms sector is permitted will be compliant in this regard. Market Entry Permit. This third approach would give MOFCOM considerable discretion and is likely to be the most practical in dealing with companies that are already listed overseas. However it does raise issues as to what happens where the determination is that the FIE is a Foreign-controlled FIE and/or it operates in a sector where there are industry qualification criteria (such as the telecoms and internet sectors) and the foreign investors are financial investors and do not meet the foreign investor qualification criteria under the relevant legislation. Will a Market Entry Permit be granted in such case and what happens if it is not granted? It is also not MOFCOM but the industry regulators who may be less open to foreign investment generally who will have a large say in the decision whether or not grant a Market Entry Permit. Presumably the various approaches will have been discussed at length and agreed with the Ministry of industry and Information Technology, the Internet and telecoms industry regulator, where VIEs are most prevalent and other relevant regulators such as State Administration of Press, Publication, Radio, Film and Television which is in charge of large swathes of the Chinese media. Using language reminiscent of that added to the rules on national security review to capture VIEs, Article 149 of the Draft Law says that "Foreign Investors and FIEs who, in violation of the Foreign Investment Law, through nominees, trusts, multi-layered investments, renting out of permits, outsourcing of operations, financing arrangements, contractual controls, offshore transactions or any other method whatsoever to circumvent the Draft Law will be subject to sanctions under the sections on investing in Prohibited Sectors or investing in Restricted Sectors without a Market Entry Permit" as appropriate (see below). Some commentators have argued that Article 149 essentially provides for a de facto ban on VIEs going forward. We agree with respect to all investments in Prohibited Sectors, but for investments in Restricted Sectors, only to the extent that it proves impossible to get a Market Access Permit when investing through a Foreign-controlled FIE, presumably when the market access criteria or permitgranting criteria are not met. LEGAL LIABILITIES FOR VIOLATIONS In addition to the legal liabilities for violation of information reporting obligations which we have discussed above, the Draft Law includes legal liabilities for various violations. If a Foreign Investor invests in a Prohibited Sector (or in a Restricted Sector without a proper Market Entry Permit), the provincial commerce authority may: (a) order such investor to cease investment and to dispose of its shares or assets, (b) confiscate its illegal gains, and (c) impose a fine ranging from RMB 100,000 to RMB 1 million or up to 10% of the11 amount of the illegal investment. This supports the concept of an effective ban on VIEs investing in Prohibited Sectors or Restricted Sectors without a Market Access Permit going forward. Furthermore, violation of conditions attached by MOFCOM to the Market Entry Permit is subject to a fine ranging from RMB 50,000 to RMB 500,000, or up to 5% of the amount of the investment, and even revocation of the Market Access Permit in severe circumstances. Violation of restrictive conditions attached in respect of national security review is subject to a fine ranging from RMB 100,000 to RMB 1 million, or up to 10% of the amount of the investment, and may trigger a new national security review. Violation of reporting obligations is subject to a fine ranging from RMB 50,000 to RMB 500,000, or up to 5% of the amount of the investment, and even criminal penalties in especially severe circumstances. As can be seen from the above, the most severe consequences are for violation of reporting obligations, a heavy price to pay for the removal of the postestablishment transaction approval requirements. IMPACT ON EXISTING FIES (NON-VIES) The Draft Law allows existing FIEs to continue their operations according to the previously approved business scope, term of operation and other applicable conditions. However, these FIEs should, within a 3-year transitional period, change their corporate forms and governance to comply with the Company Law, the Partnership Enterprise Law, the Law on Individual Proprietorship Enterprises and other relevant legislation. It is unclear whether this means a level playing field with domestic investors under the said legislation. What changes need to be made by existing FIEs during the said transitional period requires further clarification from MOFCOM. Until the required changes are made, these FIEs should follow the WFOE Law, the EJV Law, the CJV Law and their implementing rules and regulations, in respect of corporate forms and governance. It is a huge undertaking to get all FIEs in China to move to documents compatible with the rules applicable to domestic capital companies and raises the question of whether compulsion will be used at the end of that transitional period. The Draft Law is silent on how to deal with other types of foreign investment (e.g., long term loans, real property transactions) during the transitional period. We expect that the final Foreign Investment Law should address this issue. ESTABLISHMENT OF A NEW COMPLAINT MECHANISM The Draft Law establishes a comprehensive mechanism to promote and protect foreign investment and to coordinate relevant complaints including a new development of establishing central and local foreign investor complaint mechanisms, although query how effective complaining to one part of local government about the actions of another part of it will be in practice. INVESTMENT PROTECTION The Draft Law includes a number of provisions on investment protection. None are particularly groundbreaking or elaborated on in much detail, but they do generally signal an effort on the part of MOFCOM to be comprehensive in their approach and MOFCOM's desire to encourage and protect foreign investments. In content, the areas where protection is to be ensured include expropriation, state compensation, inflow and outflow of assets, and protection of intellectual property rights. For example: (i) A principle of expropriation is included, couched in terms similar to those in the EJV Law, reiterating the basic concepts that the State does not expropriate except under special circumstances, and then only as required by the social public interest, in accordance with statutory procedures, and with compensation. Similar principles on the requisition of real property and personal property located in the PRC are included as well. (ii) The right to claim compensation for damages suffered caused by the illegal exercise of the official power by the State authority or its employees, as enshrined in the State Compensation Law is given specific reference. Although already applicable in any event, this marks the first explicit mention of this in the canon of foreign investment law. Other areas, such as intellectual property rights, are stated as being protected, but without any further elaboration. This may come as something of a disappointment to those foreign investors expecting more on this front in the context of a revamp of the whole foreign investment system. CONCLUSION – A 'MIXED BAG' One of the more intriguing aspects of the Draft Law is to analyse what it does not say, rather than what it does say. For example, it makes no mention of foreign exchange regulation (in contrast to the EJV Law and its implementing regulations which devote whole chapters to the subject). One particularly interesting sector is Article 114 which reads: "Unless otherwise provided by laws or administrative regulations, the State allows foreign investors' capital contributions, profits, proceeds of asset dispositions, indemnification or compensation obtained in accordance with law and other such lawful assets to be freely remitted in or remitted out". Does this presage a full liberalisation of the RMB on the capital account by the time the Draft Law becomes law? Certainty it would seem inconsistent with the current restrictions on such transactions, even if the clear direction12 in recent years has been towards reducing foreign exchange controls on foreign investors and SAFE approvals with a move towards registrations and record-filings, with a shift towards the banks (rather than SAFE) playing a much enhanced role in the process. Overall, the best one can say about the Draft Law is that it is a "mixed bag". On the positive side it: (a) completely revamps the foreign investment approval system in place since the 80s and replaces it with a Market Entry Permit and Negative List approach; this shows that China is listening to those who voiced their opinions that it was time to move away from the "approval and Guidance Catalogue" approach that essentially meant all foreign investment projects were subject to MOFCOM approval, regardless of size, sector or sensitivity; this could properly be described as a breakthrough; (b) for the first time, non-sensitive Negative List FIEs will be established by means of registering with the AIC, as is currently the case in the FTZ; (c) foreign investors will be able to generally choose their own operating terms for FIEs; (d) the consolidation effect will make FIE law more transparent and easier to understand to most foreign investors (although the Draft Law is actually far longer than the combined EJV Law, CJV Law and WFOE Law); (e) the removal of post-establishment approvals for capital increases and so forth is a breakthrough; and (f) there are hints of RMB liberalisation on the capital account in the text. On the negative side: (a) there seems no obvious justification for adding conditions to Market Entry Permits outside the antitrust area when no such conditions were previously imposed; (b) the new FIE information disclosure obligations will be costly to implement, are cumbersome and onerous and in some cases overlap those already in place; there does not appear to be national treatment in this respect, and the information disclosure requirements may, depending on who is given access to the database, prove to be a 'gift' to domestic company and other FIE competitors already in the market or planning to enter it; (c) the national security test will become more vague and opaque as a result of the changes proposed in the Draft Law; (d) the Draft Law casts a shadow over the future viability of newly-established VIEs in China without there being any liberalisation of the underlying sectors in sight (other than to the limited extent proposed in the FTZ), potentially cutting off sources of badly–needed soft skills, technology and growth capital to Chinese entrepreneurs; the Draft Law also raises major issues about the future of existing VIEs, particularly overseas listed VIEs without offering any clear conclusion as to the outcome; and (e) the interface with the current NDRC approval system is not at all clear. We would, therefore, strongly recommend that all interested parties submit comments on the issues raised above as part of the public consultation process. This is a law which needs to be passed by the National People's Congress in full session or possibly by its Standing Committee, and one that will have a huge impact on the foreign investment market in China, so it is likely to be a long process before it becomes law, and there may be several drafts circulated before the text is finalised. It is not an exaggeration to say that few, if any, laws since China's opening to the outside world will have had such a profound and game-changing impact on the foreign investment environment in China: so whether you are a foreign investor looking at the China market for the first time, or a seasoned MNC or investor with a large portfolio of businesses in China, this is one development you cannot afford to ignore.