Beijing's Zhongguancun High-Tech Rules Break New Ground

By the end of 2000, there were over 50 state high-tech development zones nationwide, many of which have formulated their own regulations. Although such regulations were often considered progressive at the time, they pale in comparison to the Beijing Regulations.

Previous regulations generally focused on providing preferential policies to investors. In contrast, Beijing was much more ambitious in creating a market-oriented legal framework for the future development of Zhongguancun Science and Technology Zone (Zhongguancun). The Regulations govern not only the individuals and companies operating in Zhongguancun but also the regulator, imposing restrictions and obligations on the government. In addition, the Regulations aggressively address several existing shortcomings in the PRC legal system.

Protection of Investors' Interests

Article 7 of the Regulations provides that "any organization and individual may engage in any activity that is not expressly prohibited by any law, regulation or rule in Zhongguancun, except for activities that harm the public interest, disturb the social-economic order or violate public morality". That a person is free to do anything that is not expressly prohibited by law is a fundamental legal principle recognized in many countries. However, this is the first time the principle has been formally recognized in PRC law.

In the past, government authorities have been reluctant to give up their broad discretionary power to decide what can or cannot be done. Others have worried that recognition of the principle is premature given the underdeveloped state of the PRC legal system, in that many areas are still not subject to regulation.

Boldly casting aside such concerns, Beijing appears to have calculated that the benefits of encouraging investment and entrepreneurial initiatives outweighs any costs that might arise from ceding greater autonomy to economic actors in the zone. Investors will be anxious to see how this principle is translated into practice and whether the principle will be recognized at the state level.

More Investor-Friendly Incorporation Procedures and Requirements

Various government authorities are often heavily involved in the process of company formation. The government is afraid that if it fails to play an active role in the process of company formation, it may lose its ability to regulate the economy and prevent investors from establishing and operating companies for illegitimate purposes. Thus, although the establishment of companies has become much easier as China has moved from a planned economy to a more market-oriented economy, the incorporation system remains very rigid by international standards. The establishment process is characterized by regulatory heavy-handedness, with excessive mandatory requirements and little flexibility. The approval process also lacks transparency and predictability, and can be time-consuming and frustrating. Investors may often have to wait for weeks or even months to obtain the necessary approvals.

With a view to simplifying the registration process and making it more investor-friendly, the Regulations have made significant changes to the current system in the following areas.

The Approval Process

The Regulations break new ground by distinguishing between companies that require approval prior to obtaining their business licence and those that may register first, obtain their business licence and then apply for approval within three months. The Beijing government has published a detailed list of those industries that require prior approval, which includes 12 categories and 73 items.

Moreover, the Regulations also impose time limits for company registration. When the company registration agency, i.e., the State Administration of Industry and Commerce (SAIC), together with its local branches, accepts an application to establish a company it shall notify the relevant government authorities in charge of the particular line of industry within two working days. The authority in charge shall make a decision whether to grant approval within three working days. If the authority in charge fails to respond within the above time period, it shall be deemed to have granted approval. If properly implemented in practice, the new registration rules will shorten the registration process and make the company registration process in Zhongguancun more predictable.

Scope of Business

Unlike companies in other jurisdictions, PRC companies are not allowed to have a broad or unlimited scope of business or to contain catchall clauses in their articles of association, such as the company shall have the right to engage in all legal activities. Instead, the business scope of foreign investment enterprises (FIEs) and many domestic companies is limited to a narrow range of specified areas and activities, with the scope of business approved and monitored by the SAIC or the Ministry of Foreign Trade and Economic Cooperation (MOFTEC, together with its local branches).

The Regulations have departed dramatically from the current framework by providing that SAIC or other relevant agency will no longer review the scope of business prior to approval, except for those companies on the list requiring prior approval. Accordingly, most companies will be free to engage in any business permitted by law, and a company may even opt not to list its scope of business on its business licence.

Capital Contributions

Article 24 of the PRC Company Law (中华人民共和国公司法) (the Company Law) requires that intangible property cannot represent more than 20% of a company's registered capital. In certain circumstances, the ceiling is raised to 35%.² Yet even the higher ceiling creates problems for high-tech start-up companies whose most valuable asset is likely to be their intellectual property.

Article 11 of the Regulations provides that if one party uses high-tech research results as its capital contribution, the parties may negotiate the ownership percentage such research results represent. Beijing AIC has issued a notice clarifying that, in Zhongguancun, parties to a domestic company may contribute 100% of the registered capital in intellectual property while the parties to a FIE may contribute up to 60%.³

PRC Natural Person As a Party to Joint Venture

The PRC Sino-Foreign Equity Joint Venture Law (Revised) (中华人民共和国中外合资经营企业法) and PRC Sino-Foreign Cooperative Joint Venture Law (Revised) (中华人民共和国中外合作经营企业法 ) both provide that only "PRC enterprises and other economic organizations" may form joint ventures with foreign parties. PRC citizens are not permitted to act as a party to a joint venture. This reflects the government's deep-rooted suspicion of individuals as being less trustworthy than organizations. In practice, this limitation has forced PRC individuals to form a company first to hold their interest in a joint venture. Article 56 of the Regulations, however, makes it clear that domestic organizations or individuals can form high-tech equity or cooperative joint ventures in Zhongguancun.

Articles of Association Review

The registration and approval authorities often conduct a substantive review of the articles of association filed by companies, which leads to various problems in practice. To reduce their workload, some agencies require companies to use their standard, usually over-simplified, forms. Even more worrisome, they may insist on amending or deleting certain clauses that they believe are unfair or improper, in the process increasing obligations on one of the parties and thus undermining the results of months of hard-fought negotiations.

The Regulations limit the broad discretionary power granted to the registration and approval authorities. The authorities now only check five relatively uncontroversial areas: the name of a company; the domicile and names of shareholders; the numbers of directors; the amount of registered capital; and the contribution schedule. Accordingly, investors are free to draft their articles of association as they like, provided they comply with generally applicable laws and regulations.

Efforts to Facilitate Venture Capital

Reflecting an appreciation of the importance of venture capital in the development of high-tech industries, the Regulations contain many new rules to encourage venture capital investment in Zhongguancun.

Limited Partnerships

In many countries, venture capital funds often take the form of a limited partnership where general partners (usually fund managers) bear unlimited liability and limited partners (usually investors) bear limited liability to the extent of their capital commitment. The attraction of a limited partnership is that on the one hand investors, as limited partners, enjoy the same kind of protection as shareholders of a company, while on the other hand they can avoid double taxation imposed on shareholders of a company. The PRC, Partnership Enterprises Law, adopted in 1997, does not contain any provisions on limited partnerships, and thus limited partnerships have not been recognized as a form of business organization in China prior to the passage of the Regulations.

Article 25 of the Regulations states that venture capital entities may take the form of a limited partnership. To further shore up the legal basis for limited partnerships, in February 2001 the Beijing government passed the Administrative Rules on Limited Partnership (Limited Partnership Rules), which contain 17 provisions governing the formation, operation and dissolution of a limited partnership. Though the Limited Partnership Rules are relatively simple, they do lay out a basic legal framework for limited partnerships for the first time in China.

Capital Contribution and Venture Capital Investment

The capital contribution requirements under Chinese national laws and regulations are rather rigid. For domestic companies, all shareholders must make a full contribution of registered capital before a company obtains its business licence. Although capital contribution is made after incorporation for foreign investment enterprises, all registered capital must be contributed within a fixed period of between six months to three years depending on the total investment of the company. In any event, at least 15% of the registered capital must be contributed within three months after a foreign investment enterprise is established.

The requirements offer little flexibility to companies that wish to match their capital injection with their actual business needs. Realizing that venture capital funds often need more flexible capital contribution schedules, Article 26 of the Regulations provides that investors to a venture capital entity may contribute the registered capital according to a schedule agreed upon by the investors.

Article 12 of the Company Law imposes further restrictions on PRC companies, providing that except for those investment companies (i.e., holding companies) established in accordance with the regulations of the State Council, the aggregate investment of a company in another business entity cannot exceed 50% of the investing company's net assets. As the criteria for establishing investment companies are quite high, the ability of ordinary PRC companies (including foreign investment enterprises) to make investment is seriously curtailed. In contrast, Article 26 of the Regulations provides that a venture capital company may invest all its capital, in keeping with international venture capital practice.

It is interesting to compare the Limited Partnership Rules with the Establishment of Foreign-funded Venture Investment Enterprises Tentative Provisions recently issued by MOFTEC, SAIC and the Ministry of Science and Technology (the VC Regulations). Though the announced purpose of the VC Regulations is also to encourage investment in high-tech industries and to improve the venture capital investment system in China, the VC Regulations are surprisingly restrictive in view of China's anticipated entry to the WTO.

For example, the VC Regulations set forth high qualifying standards for foreign and Chinese investors. The total assets under the management of a foreign investor for the preceding three years must not be lower than US$100 million (Rmb100 million for Chinese investors) and at least one foreign investor's investment in the venture capital company shall be not less than US$20 million. In contrast, the Limited Partnership Rules do not impose any qualification requirements on potential investors.

In terms of capital injection schedules, the VC Regulations follow the rigid rules of ordinary foreign-invested companies, i.e., at least 15% within three months of incorporation and full contribution generally within three years. As noted previously, the Limited Partnership Rules do not set a specific time limit.

Under the VC Regulations, all foreign-invested venture capital companies must be approved by MOFTEC at the central level, which often entails a prolonged and uncertain process. In contrast, under the Limited Partnership Law, venture capital companies may be approved locally.

Nevertheless, the VC Regulations do share a common breakthrough with the Limited Partnership Rules: Article 16 of the VC Regulations recognizes limited partnership as a permitted form of venture capital. This is the first time that limited partnerships have been recognized in national legislation.

Antitrust

Although China began to work on an antitrust law in the early 1990s, the law has yet to be promulgated. The main obstacle is that despite more than two decades of market-oriented reforms, many key industries such as telecommunications and public utilities are still dominated by a few state-owned companies. Seeking to create a level playing field and to provide the legal groundwork for future regulation of antitrust activities, the Regulations briefly set forth certain antitrust principles.

Article 20 provides that market participants in Zhongguancun cannot prohibit or restrict normal commercial competition by way of pricing conspiracy, market division, output limitation or other means. Article 21 states that market participants in Zhongguancun cannot impose commercial terms on other market participants by taking advantage of their monopoly position in the market. Article 22 dictates that unless agreed upon in accordance with law, market participants cannot restrict their counterparts to a transaction from entering into further transactions.

Compared with other sections of the Regulations, those provisions are general and vague. There is no definition or explanation for many key terms such as "imposing commercial terms" or "market division". Article 23 briefly mentions that the government and its subordinate departments shall take measures to prevent monopolistic activities. Unfortunately, it is not at all clear which government department shall assume such responsibilities, what criteria and procedures the department in charge will apply in deciding the existence or absence of antitrust activities, and what legal or administrative measures it can take to punish antitrust activities. At present, these antitrust provisions do not appear to be enforceable in practice.

Regulation of Government Activities

For better or worse, the government is accustomed to playing an active role in many aspects of economic life, with the exercise of administrative powers often characterized by lack of transparency and accountability. In an effort to make the government more efficient, transparent and accountable, the Regulations have devoted a special chapter to regulating the regulator.

Transparency

Article 61 of the Regulations requires that the regulation-making authority shall, in a timely manner, publish regulations and administrative rules about Zhongguancun in gazettes, media and government websites before these rules become effective. Article 63 states that a public hearing shall be held before the adoption of any important policy. Article 65 provides that the scope, standards and procedures of administrative charges shall be publicly announced and in conformity with laws and regulations. Persons have a right to refuse to pay any charges collected not in accordance with the law.

Efficiency

Article 68 requires that the administrative system of Zhongguancun shall be established based on the principles of high-efficiency and a reduction in the number of intermediate levels. Article 69 requires that the municipal and district government shall delegate the regulatory powers relating to Zhongguancun to the administrative organs of Zhongguancun. Article 63 further requires that the government authority in charge of granting approval shall decrease and simplify the approval process and publish the conditions, standards, procedures and time limits of the various approval processes.

Accountability

Article 60 provides that administrative organs shall adopt "administrative responsibility" and "wrongdoing accountability" systems. As a result, administrative agencies and government officials shall be held responsible and punished for their wrongful acts, including the failure to act. Chapter 7 sets forth more detailed rules regarding administrative and other liability. The Regulations also establish a complaint system where any market participants who believe that their lawful rights have been infringed by administrative activities can file a complaint with a specific entity. Such entity must respond within 10 days.

Conclusion

It would be unrealistic to expect that the investment environment of Zhongguancun will change overnight as a result of the promulgation of the Regulations alone. Only time will tell to what extent the well-intentioned principles set forth in the Regulations will be implemented in practice. At minimum, however, the Regulations have laid the foundation for future positive changes.

As is typical in China, the path-breaking nature of the Regulations raises questions about their legality in some instances. Some of the provisions in the Regulations are inconsistent with superior law, while other provisions venture into territory not yet expressly addressed by existing superior laws and regulations. Technically, the Regulations cannot alter national laws or regulations, as they are guizhang and thus subordinate to laws passed by the National People's Congress and regulations adopted by the State Council. Investors run the risk that provisions in the Regulations that are inconsistent with higher-level legislation will be ignored by the courts or struck down as part of the review process.

To be sure, local legislators often pass regulations that at the time of promulgation are at odds with superior legislation in order to respond to the needs of the marketplace. In some cases, the central authorities will allow or even encourage such experimentation. If the results prove positive, central legislators will then enact or amend national laws or regulations incorporating the changes. Thus, the Regulations could very well be a harbinger of what is to come nationwide.

At the same time, investors should be aware that legal basis for some of the changes is shaky. Accordingly, investors are advised to consult PRC attorneys for advice as to the risks in relying on specific provisions that are inconsistent with national level legislation.

Endnotes

1 The Regulations were passed on December 8 2000 and became effective on January 1 2001.

2 See Article 3 of State Science and Technology Commission and State Administration for Industry and Commerce, Several Questions Concerning the Use of High and New Technology Achievements as Capital Contributions for Subscription of Shares Provisions, promulgated July 4 1997.

3 The Experimental Opinion Regarding Registration, Change of Form and Reorganization of High Technology Companies in Zhongguancun Science and Technology Zone, issued on May 16 2000.