Scott Yu and Frank Jiang of Zhong Lun Law Firm highlight recently introduced national security measures for review of foreign investments including its broader reach within China, the scope of M&A targets and expanded sectorial coverage, and the new review mechanism coordinated by the NDRC.
While China has endeavored to streamline foreign investment approval through pre-establishment national treatment plus a negative list system under the framework of the PRC Foreign Investment Law (中华人民共和国外商投资法), there has been an increased emphasis on safeguarding national security, a trend also gaining more prominence in other jurisdictions such as the U.S. (through the review of the Committee on Foreign Investment in the United States ) and the EU (via an foreign direct investment screening). As part of these efforts, on Dec. 19, 2020, China’s National Development and Reform Commission (the NDRC) and Ministry of Commerce (MOFCOM) published the Measures for the Security Review of Foreign Investments (the FISR Measures) (外商投资安全审查办法), becoming effective as of Jan. 18, 2021.
The FISR Measures are not the first laws in China to address national security concerns in foreign investments, but it is the first ministerial regulation on this topic. The FISR Measures are preceded by the Circular on the Establishment of a System for Security Review of Acquisition of Domestic Enterprises by Foreign Investors (the Circular) (关于建立外国投资者并购境内企业安全审查制度的通知), published by the General Office of State Council in 2011, and the Trial Measures for the National Security Review of Foreign Investments in Pilot Free Trade Zones (the Free Trade Zone Measures) (自由贸易试验区外商投资国家安全审查试行办法), also by the General Office of State Council in 2015. Although not expressly provided, it is understood that the FISR Measures supersede the Circular and all other regulations covering the same topic, and will operate as the primary regulation for national security reviews on foreign investments in China. As a result, investors are advised to consider national security review requirements for plans to establish their presence in China, especially in certain key sectors or special areas. Some highlights are discussed below:
A. Broader Scope of Applicable Transactions
Compared with transactions subject to review under the Circular, the FISR Measures largely broaden the scope.The Circular, as suggested by its title, only regulated M&A transactions of domestic targets by foreign capital, while under the FISR Measures, all types of foreign investments within the territory of the PRC are covered by it, including greenfield investment (e.g. establishment of joint ventures or wholly-owned subsidiaries), acquisition of equities or assets of a domestic entity, and other forms of investments (Article 2).
The FISR Measures do not provide details of “other forms”, but in the Free Trade Zone Measures a security review extends from M&As to greenfield investments and other forms of investments including, but not limited to, contractual controls, nominee holdings, trusts, multiple layer investments, extraterritorial transactions, leases and subscriptions of convertible bonds.It remains to be tested if the FISR Measures will adopt same interpretation for the “other forms”.
Moreover, pursuant to Article 22 of the FISR Measures, any purchase of shares of domestic enterprises by foreign investors through stock exchanges or other stock trading platforms approved by the State Council may also trigger application of the FISR Measures, to the extent that the purchase impacts or may impact national security. A strict interpretation of the article would mean that it is possible that purchase of stocks of Chinese public companies, such as A-shares and H-shares, will also trigger national security review if national security is of concern.
B. Evolving Scope of M&A Targets Triggering Security Reviews
It is also interesting to note that, in the event that investments are conducted by M&A, the scope of M&A targets of which acquisitions will trigger national security review has been evolving in the Circular, the Free Trade Zone Measures, and the FISR Measures.In the Circular, such targets include:
- Equity in non-foreign investment enterprises (FIEs);
- Equity in FIEs owned by their Chinese shareholders;
- Equity in “enterprises within China”, if it is acquired by foreign investors through FIEs established by such foreign investors;
- Assets of “enterprises within China”, whether the acquisition is conducted directly by a foreign investor, or through FIEs established by such foreign investors.
The Free Trade Zone Measures, on the other hand, require a security review when a foreign investor acquires equity or assets of an “established enterprise” in a free trade zone through M&A. It seems that under the Free Trade Zone Measures, the government intends to expand the scope to cover equities initially owned by foreign shareholders, although the measures only apply to enterprises established within the Free Trade Zones.
Also, the FISR Measures provide that when “a foreign investor acquires shares of equity or assets of an enterprise within China through mergers and acquisitions”, such acquisition will be subject to national security review. It should be noted that the FISR Measures no longer distinguishes between FIEs and non-FIEs, and it also clarifies that “within China” means “within the People's Republic of China”, and the acquisition could be either directly or indirectly (Article 2). In light of the above, an M&A between two foreign entities may also trigger application of the FISR Measures, if the target company has a subsidiary(ies) within China, and the sectorial tests are met (see below). However, whether Chinese authorities will take such a rigorous approach remains to be seen.
C. Expanded Sectorial Coverage in Control Tests
The FISR Measures follow the same approach taken by the
1. investments in national defense security related areas such as:
- military industries;
- industries that support military industries;
- other sectors having a bearing on national defense security; and
- the surrounding areas of military facilities and military industrial facilities.
2. acquisition of effective control of enterprises that are engaged in the areas of
- important agricultural products;
- important energy and resources;
- important equipment manufacturing;
- important infrastructure;
- important transportation services;
- important cultural products and services;
- important information technology and internet products and services;
- important financial services; and
- key technologies and other important areas that have a bearing on national security.
The major difference between the test used by the Circular, and that under the FISR Measures is the expansion of sectorial coverage to more areas including culture, information technology and the internet, and financial services (Articles 4).This change signals the Chinese government’s increasing attention towards the services sectors and their impact on national security.Like the Circular and Free Trade Zone Measures, the FISR Measures use the term “important” to qualify the products and areas that may attract a national economic security review, but the measures do not provide further details on how to determine the level of “importance”.It is expected that there will be implementing rules or published cases to provide more guidance on this point.
As to “effective control”, the FISR Measures adopt a similar definition used in the Circular, which includes three scenarios:
1. foreign investors holding 50% or more of the shares of the target entity;
2. if the shareholding percentage is less than 50%, where foreign investors may be able to exert, with voting right vested upon their shares, a substantial influence on the resolutions of the board of directors, the shareholders’ meeting or the general meeting of shareholders of the target entity; and
3. other circumstances where a foreign investor may exert substantial influence on the business operation decision-making, human resources, financial affairs, technology, etc. of such enterprise.
There is currently no statutory or practical interpretation of what is meant by “substantial influence” for national security review purposes, and it is anticipated that this definition will be tested in the future operation of the FISR Measures.
D. Other Highlights in the FISR Measures
A standing review mechanism coordinated by the NDRC. In contrast to an ad hoc inter-ministerial joint committee under the State Council and coordinated by the NDRC and MOFCOM as reviewing bodies provided under the Circular, the FISR Measures provide that a foreign investment security review office (“FISR Office”) will be set up within the NDRC, led by both the NDRC and MOFCOM. (Article 3). The FISR Office will undertake the daily work of national security review on foreign investments. A filing for review must be submitted to the FISR Office of the NDRC, instead of MOFCOM, as previously prescribed in the Circular.
Review phases and timeline. Similar to the procedure under the Circular and the Free Trade Zone Measures, a decision on whether to conduct a review will be provided within 15 working days of receipt of the notification materials. Where there is a decision to proceed with a review, a preliminary review must be completed within 30 working days. The investment will be greenlighted if no national security concern arises during this phase. Alternatively, a special review procedure will be initiated and can last up to 60 working days, subject to extension under special circumstances (Articles 7-9). It is important note that the review time limits start to lapse only when the authority recognizes all necessary application materials are completed, and it is not uncommon that authorities may request for supplements of additional materials after initial filing. Therefore, the actual review time is likely to be longer than that provided for under the regulation.
The FISR Measures also create a consultation mechanism similar to that under the merger review rules. Article 5 provides that before filing an application for foreign investment with the NSR Mechanism Office, the parties may consult with the NSR Mechanism Office on the relevant issues.
Conditional clearance available. The FISR Measures adopt the same approach under the Free Trade Zone Measures on types of decisions for national security review filings. In addition to decisions of approval or prohibition, the FISR Office may also decide to conditionally clear a transaction if remedial measures can be implemented to address security concerns identified during the review. For conditionally cleared foreign investment, the FISR Office may coordinate with competent regulators or local government to monitor compliance of remedies, including requiring the transaction parties to provide relevant evidence, conducting onsite inspections and taking other measures to verify the implementation of the imposed conditions (Articles 12 and 13)
Consequences for violations. If a foreign investment is implemented without notification and remains so after requirements by the FISR Office, the office may, on grounds of national security concerns, order that the transaction be reversed or the relevant business/assets concerned be disposed of. A similar mechanism also applies where a prohibited foreign investment is implemented despite a decision to prohibit the investment, a clearance decision is made based on false or incomplete information or a conditionally cleared transaction is not implemented in accordance with the restrictive conditions imposed (Articles 12, 16-18). In addition to the above disposal or unwinding procedures, non-compliance will result in negative credit history of the parties involved, which may impact their future activities in China (Article 19).
E. Key points from the new rules
Issued as a ministerial regulation by the NDRC and MOFCOM, the two primary Chinese ministries responsible for foreign investments, the FISR Measures are expected to have material impact on foreign capital’s entry into China. As discussed above, due to the absence of an official guidance or published decisions on the subject, there are still a number of gaps to be filled on how this new regulation will be implemented. However, investors are advised to take a more cautious approach to assess how the FISR Measures will affect their plans for either greenfield investments in China or M&A transactions, and even though the Chinese operation may not be the primary target but their assets or services may also be subject to national security review.