China's Foreign Venture Capital Law: How Far From Customary International Fund Practice?

The Tentative Provisions permit one or more foreign investors to join with Chinese investors to form an onshore investment company, and also permit the formation of an onshore wholly foreign-owned investment company. They do not on their face attempt to impose restrictive rules about investment company management structures, and they recognize that customary international practice involves allocation of gains and losses in ways that would startle a person accustomed to a simple corporate entity capitalized solely by ordinary common stock.

Unfortunately, the Tentative Provisions are based on the existing rules for foreign investment in China, which are mainly based on simple joint venture models or assume 100% foreign ownership of an elementary limited liability company. This makes it difficult to replicate in China the venture capital fund structures that have become typical in more open economies. As a result, this promising beginning may lead into blind alleys.

Available Investment Vehicles May Not Meet the Requirements of Offshore Investors

Under the Tentative Provisions, a foreign invested venture capital enterprise (FIVCE) can only be organized under (a) the existing foreign investment joint venture rules, or (b) the existing rules governing the formation of wholly foreign-owned enterprises (WFOEs). Each is the subject of its own set of "corporate governance" rules, setting forth basic organizational and operational requirements. In each case a FIVCE may be formed only on application to and approval by the Ministry of Foreign Trade and Economic Cooperation (MOFTEC).2

Joint Venture Entities

A joint venture FIVCE can be formed under three related but different sets of rules. Two of these are in the legal form of limited liability companies taxable as corporations and do not offer much flexibility for unusual management or gain and loss allocation structures.3

The third type of permissible joint venture FIVCE - the "non-legal person cooperative joint venture" - is taxed as a partnership, permits partnership-type flexibility in the allocation of gains and losses, and does not require the relatively rigid joint venture management structure required for joint ventures organized as limited liability companies.

However, any joint venture FIVCE must have at least one Chinese investor that meets the asset and experience qualification requirements set forth under Article 6.1 of the Tentative Provisions. There probably are not many Chinese entities today that could meet those requirements. And experience suggests that, if one can be found, it will demand significant or even primary management responsibility for the joint venture. This is unlikely to be satisfactory to most foreign venture capital investors unless the Chinese investor is an entity with which they have an existing long-term relationship.

WFOEs

A FIVCE may also be organized under the rules governing WFOEs. A WFOE-type FIVCE has the same investor requirements as a joint venture FIVCE, except that it does not require the participation of any Chinese investor. However, the typical WFOE today has a single foreign investor, is organized as a limited liability company taxable as a corporation, and subsists under laws that do not contemplate the flexible allocations of gain and loss in standard venture capital funds.4 While in theory a WFOE can be formed as a Chinese law partnership rather than as a limited liability company taxed as a corporation,5 if it has ever happened, it is rare and not well publicized.

There are thus some significant hurdles to setting up a FIVCE that would function, for profit and loss allocation or tax and management purposes, in the manner of venture capital funds conventionally used in the rest of the world. Only a non-legal person CJV seems to meet this requirement, and, as noted above, its use will be somewhat complicated by the need to have a reasonably wealthy Chinese partner with asset management experience.6

Practical Problems in Creating an Onshore Investment Vehicle

The Vehicle Itself Must be Structured as a Fund

Embedded in the Tentative Provisions is the assumption that the FIVCE itself serve as the primary organizational vehicle for the venture capital investors. The Tentative Provisions do not seem to permit a fund organized under, say, Cayman Islands law, to form a single-owner FIVCE that will then make Chinese venture capital investments.

Instead, the Tentative Provisions specify that every FIVCE, even one structured as a WFOE, must have at least one "Foreign Investor" with significant venture capital fund management experience that commits to at least 3% of the FIVCE's total investment (Article 5.1), and must have one "Foreign Investor" that can bear the risk of venture capital investments, had total net assets of at least US$100 million for the year prior to the FIVCE's formation and commits at least US$20 million
to the FIVCE.7 The "management" foreign investor must have personnel (how many is unstated) with three years of venture capital fund management experience, must have had in the aggregate at least US$100 million under management during the past three years,8 and must have invested at least US$50 million of its managed capital within the past three years.9

If it were possible to get around the barrier formed by the taxation of a WFOE as a corporation, one could try to satisfy the "two investor" requirement applicable to a WFOE-type FIVCE by forming an offshore venture capital fund (for example, under Cayman Islands law), and then have the fund and its manager arrange to invest in a new FIVCE in the ratio of 97 to 3, with a very simple organizational structure. All adjustments necessary to maintain conventional cash returns as between the manager and the fund's investors, and any other management details inconsistent with Chinese regulatory requirements, could then be covered at the Cayman Islands level. But the requirement that the principal money investor in the FIVCE have had at least US$100 million in net assets for the past year would seem to mean that no newly-formed offshore fund could easily qualify as the principal money investor in the FIVCE.

It will be worth asking the Chinese regulatory authorities whether they would look through our hypothetical Cayman Islands offshore fund to the actual investors in the fund to determine whether the US$100 million net assets/US$20 million investment test was satisfied as to at least one investor in the Cayman Islands fund. But it is more likely, at least in the early years of implementation of the Tentative Provisions, that one offshore institutional investor would have to be a direct investor in the FIVCE in order to make sure that the US$100 million pre-existing asset requirement is satisfied.

Organizational Documents are Subject to Chinese Government Review

If the FIVCE must be the principal fund organizational vehicle, it would seem to follow that the principal fund operating rules (i.e., at least the equivalent of the fund partnership agreement) will need to be incorporated in an agreement among the FIVCE and its investors which in turn will have to be translated into Chinese and reviewed and approved by MOFTEC. This is likely to include all agreements relating to the sharing of gain or loss among the FIVCE investors and to the transfer of investments in the FIVCE. The difference between venture capital partnerships and simple industrial joint venture partnerships will undoubtedly make for slow review of the first FIVCE documents filed for government review and approval. We suspect that many foreign investors and fund sponsors may not want to reveal the full details of their partnership structure to Chinese government authorities.

As discussed in the immediately preceding subsection of this article, it may be possible with a WFOE-type FIVCE to keep the bulk of the fund arrangements offshore pursuant to separate agreements among the investors, with the onshore FIVCE assuming a very simple structure. But this will not work if the FIVCE must be a joint venture with one or more Chinese investors (which, as noted, may be the only way to get partnership tax treatment for the FIVCE), as the ability of the Chinese investors to participate in any offshore investment vehicle is likely to be significantly limited by applicable Chinese laws and regulations.

Inflexible or Burdensome Operational Requirements

There are also operational procedures made applicable to FIVCEs by the Tentative Provisions that are somewhat inconsistent with standard fund practice.

Capital Vesting Schedule

The Tentative Provisions strictly follow traditional Chinese foreign investment practice by requiring that the FIVCE must have its total invested capital approved in advance by the government authority, that its shareholders must invest at least 15% of the approved total capital within 90 days of the date the FIVCE receives its business licence, and it must invest all of the approved total capital within three years of such date (see Article 7). Thus the five-year investment periods and "just in time" funding provisions typical to most international private equity funds are apparently not permissible.10

A seemingly obvious solution to this problem is to have the FIVCE approved initially with a very small capital amount, and to increase approved capital only as the FIVCE identifies investment opportunities.

There are, however, two difficulties with this approach. First, 15% of the minimum size of a FIVCE (see Article 5.2) will be a good bit more than mere organizational expenses, and fund investors may not want to have an extra couple of million dollars lying about in the hope that it will be put to use within four or five months of the initial closing.

The second, greater difficulty would arise because the FIVCE is obviously a foreign investment enterprise (FIE) and the Tentative Provisions treat any prospective investee of an FIVCE as a prospective FIE (Article 24).11 Normal Chinese practice requires administrative review and approval of any investment that causes a Chinese company to become an FIE, and of each increase in the authorized capital of an existing FIE. We suspect that many investors and fund managers will be uncomfortable trying to outwit the 90 day and three year funding requirements on the assumption that the approvals required for increase in the FIVCE's capital can be obtained on a schedule that will coincide with granting of the approvals required for a specific investment by the FIVCE in a target company.

Reporting Requirements

The Tentative Provisions include a requirement that each FIVCE file semi-annual reports of its investment and operating activities with MOFTEC (Article 27). The content of these reports is not specified, but they are likely to require disclosure of amounts invested, the identity of the investors and, when investments are disposed of, the gains or losses involved. We suspect that many fund managers will be uncomfortable in providing fund-related financial performance information to government authorities other than tax authorities.

Administrative Approval of Portfolio Investments and Investment Exits

The Tentative Provisions also raise difficult questions about making and exiting from portfolio investments. As noted above, a portfolio investment by a FIVCE in a Chinese entity will be treated as a foreign investment, and will be subject to Chinese government review and approval.

Exit options will also be scrutinized. Public offerings by Chinese entities are regulated by the state on substantive grounds, frequently with reference to non-market elements, without regard to whether the proposed offering is onshore or offshore. Moreover, a private transfer of a FIVCE portfolio investment will be directly examined by MOFTEC in an as yet unspecified manner, but which is likely to include review both of the identity of the purchaser and of the terms of purchase (see Article 26). This process could be both unpredictable and time consuming. Finally, FIVCE's "put" rights (forced portfolio company buy-backs) will be the subject of explicit governmental scrutiny and further rulemaking.12

Corporation Law Considerations

Outside the scope of the Tentative Provisions is a further set of issues posed by the relatively undeveloped state of company law in China. Most private companies are still organized as limited liability companies. Such a simple structure leaves no easy place for the typical capitalization of a venture capital portfolio company, in which the founders provide little capital but much sweat equity, thereby obtaining a far larger proportion of the company than would be justified by their cash investment. And even if the target company is organized as a company limited by shares, there is no provision in Chinese company law for the issuance of preference shares.

These corporate law limitations could probably be overcome, in large part, by sophisticated contractual arrangements between the FIVCE and the founding shareholders of the target company, specifying the allocation of future gains and losses and setting typical financial investor management rights. But any such arrangements will present an enforceability hazard not present in an investment structure in which the financial investor's rights and return are embedded in the target company's organizational documents and thus at least nominally protected by the applicable companies law.

These limitations could also be overcome (and have been, in some cases) by placing an offshore holding company between the financial investors and the onshore target company, but the acceptability of such arrangements to the Chinese regulatory authorities is unclear. And if the target company has gone to the trouble of forming an offshore holding company, there would be no real need to invest through a FIVCE.

Conclusion

We think that the Tentative Provisions are likely to precipitate a flurry of efforts by international fund managers to identify potential Chinese investors with whom they could structure FIVCEs under the non-legal person CJV rules. We suspect, however, that this will be difficult to do without embodying the bulk of the venture capital fund documentation in the organizational documents of the FIVCE, and that this may lead to significant review delays and possible Chinese attempts to dictate the substance of the venture capital fund documentation. Nonetheless, the history of Chinese foreign investment has shown that the Chinese authorities will, more often than not, reward foreign investors who have demonstrated their interest in China by working patiently with the relevant regulators to reach agreement on investment structures that satisfy the Chinese authorities and also meet the structural or other practical requirements of the foreign investor.

We do believe that the Tentative Provisions provide a window of opportunity for a patient fund sponsor to try to work out with the regulatory authorities a FIVCE structure that adheres closely to the Tentative Provisions, but solves or at least limits some of the problems outlined above, such as permitting the formation of a WFOE-type FIVCE in partnership form with limited partnership liability concepts, permitting a "look-through" to the investors in an offshore fund to establish the existence of a qualified foreign investor with over US$100 million in assets, and eliminating sanctions for failure to invest within the 90 day/three year windows.

Endnotes:

1 See Article 16.

2 Existing Chinese foreign investment law requires a feasibility study report to be filed and examined by the government authority for any kind of Sino-foreign joint ventures or WFOEs. It is worth noting that at least on its face Article 10 does not seem to require a feasibility report to be filed for any FIVCE (although the catch-all provision under Article 10.9 which demands any "other document that may be requested" by MOFTEC might be interpreted by MOFTEC as including the right to demand a feasibility report if they wish).

3 Article 15 of the Tentative Provisions states that the articles of association of a limited liability FIVCE may provide for performance-based compensation to management. This might be extended to encompass conventional "carried interest" forms of fund management compensation, but it is likely to take intensive discussions with the Chinese tax authorities to determine whether this kind of compensation structure can be made efficient in the context of an entity taxable as a corporation.

4 See, however, the discussion in note 3.

5 See Article 18 of the PRC, Wholly Foreign-owned Enterprise Law Implementing Rules (Revised).

6 The provision for the limitation of liability of certain investors in the FIVCE is stated to be applicable only to non-legal person CJVs, which require Chinese investors. Even if the authorities would permit organization of a WFOE in partnership form, we do not see any basis in the Tentative Provisions that would extend limited liability to its partners (see Article 16).

7 Article 5 of the Tentative Provisions provides that a single foreign investor is sufficient if it meets both the "management experience" and the "deep pocket" requirements. But a joint venture FIVCE requires at least two investors and a single investor FIVCE would under existing rules be a taxable entity.

8 This requirement is not clearly phrased. The Chinese text could be read to mean that the test would be satisfied if (i) you had managed in the aggregate US$100 million during the past three years, or (ii) you were managing at least US$100 million at any time during the past three years, or (iii) you have had an average of at least US$100 million under management for the past three years. A similar ambiguity exists in the qualification provisions applicable to the Chinese investor under item 2 of Article 6.1.

9 Additional foreign investors are permitted without a net asset test so long as they can bear the investment risk and commit at least US$10 million each to the FIVCE (Articles 5.2 and 5.3). This would be a threshold investment level that might be unattractive for many potential fund sponsors.

10 Many venture capital investors will be unwilling to risk having their capital commitments drawn down without any assurance that they will be put to productive use, and few managers will want to see their IRRs brought down because they are holding uninvested cash for lengthy periods.

11 It is interesting to note that any investee company of a FIVCE with at least 25% equity investment from the FIVCE will be issued a Foreign Invested Enterprise Approval Certificate (Article 23). Since FIVCE requires a minimum foreign ownership of only 25% (Article 7), this would effectively cause an investee company which may only have 6.25% actual foreign ownership (i.e. 25% of 25%) to be accorded FIE treatment under Chinese law.

12 See Article 20.