It's SAFE Again for China Venture Capital Round-trips & Red-chip Listings

The repeal of SAFE's previous January and April circulars,⁵ as of November 1, 2005, is the first effect of the Circular. Other effects will take time to materialize as local SAFE offices digest the Circular, obtain further guidance from the SAFE head office and go through the typically gradual process of working out interpretation and implementation.

One firm date that will soon begin to put pressure on some residents and the enterprises controlled by them is March 31, 2006, which is the deadline for residents to "supplementally handle" registration of any previously completed round-trip investments in which they hold interests (Section 8).⁶ A vaguer requirement regarding supplemental registration submissions - without a deadline - existed before the Circular's issuance and has been deferred by most concerned residents to await more details.⁷

WHO IS AFFECTED?

The Circular's most important and direct effects are on resident individuals. It will also have important implications for foreign venture capitalists and private equity investors contemplating investments through special purpose companies in which "control"⁸ may be regarded as held by residents.

The definition of "domestic resident natural persons" (resident individuals) covered by the Circular includes not only individuals holding a China domestic identity document, but also other individuals who "habitually reside in China for reasons related to [their] economic interests" (Section 1, Paragraph 3). This includes citizens of foreign countries along with permanent residents of Hong Kong, Macao and Taiwan.

Informal discussions with local SAFE officials give the impression that they have not yet made much progress in developing criteria for determining whether or not a particular foreigner meets this residence standard for future and/or past offshore investments. Foreigners working in China will need to be attentive to further developments of SAFE's policy and practice on this point.

The Circular culminates a series of major changes affecting resident individuals who benefited from legal loopholes before January 24, 2005, but since then have endured an effective freeze on investments through offshore companies.

"'Domestic resident natural persons' (individuals) includes not only individuals holding a China domestic identity document, but also other individuals who 'habitually reside in China for reasons related to [their] economic interests'."

Besides resident individuals, the Circular also applies to "domestic resident legal persons" (enterprises and other economic organizations) (Section 1, paragraph 3) including the newly recognized "domestic venture investment enterprises" (Section 9), but makes few substantive changes for these entities. PRC enterprises and other economic organizations have long been, and continue to be, subject not only to SAFE registration procedures but also to approval procedures with the Ministry of Commerce (MOFCOM), covering much of the same ground.

REGISTRATIONS VS APPROVALS

Registrations with SAFE by resident individuals do not require prior approval by MOFCOM. This important point is made clear by the differing lists of submission documents for individuals in comparison to resident legal persons.⁹ But the SAFE "registrations" required by the Circular do require applicants to submit so much substantive information that these procedures are likely to feel similar to "approvals" or "verifications".

Several Stages Entail SAFE Procedures

A series of procedures with the local SAFE office (some of which may later be consolidated) are required under the Circular to be handled by residents at the following stages of a round-trip investment:

i) Before establishing or taking control of a special purpose company abroad (Section 2);¹⁰

ii) [If] injecting a domestic enterprise's assets or equity... into a special purpose company (Section 3);¹¹

iii) [If] conducting an equity financing exercise abroad after injecting assets or equity into a special purpose company (Section 3);¹² and

iv) Within 30 days of a material change (other than a round-trip investment) in the capital structure (including 'external guarantees') of a special purpose company [controlled by such residents] (Section 7)."¹³

In addition, the Circular includes a reminder that a domestic enterprise receiving round-trip investments or loans from a special purpose company's financing proceeds must handle the same procedures as any other domestic enterprise engaging in these types of foreign currency transaction (Section 5).¹⁴

Filing Form, Instructions & Disclosure Scope

SAFE's detailed preparations to clarify related issues are shown by its issuance of a standard Form for Overseas Investment Related Foreign Exchange Registration of an Individual Domestic Resident,¹⁵ together with seven paragraphs of instructions.

The text of the instructions¹⁶ appears to require disclosures described so broadly that they might be unrelated to any special purpose company or specific round-trip investment. Instruction No. 2 specifies that "all enterprises" registered outside China in which a filing resident has a direct or indirect shareholding must be included in the form. Instruction No. 5 appears to specify that ownership percentages must be included not only for "special purpose companies" but also for "listed companies outside China". It remains to be seen whether SAFE will indeed require disclosure of unrelated external investments.

When a number of residents must make filings for the same special purpose company or round-trip investment, their SAFE filings are required to be handled by one or two of them. The residents that make the SAFE filings must receive a letter of authorization from the others (Section 10). Each resident must, however, sign to confirm the contents of the form (Instruction No.7).

PAYBACKS

Remittances to a special purpose company from its invested enterprises in China are permitted, but only after compliance with required registration and amendment procedures. As specified in the Circular, these remittances include "profits, dividends, liquidation proceeds, equity transfer proceeds, capital reduction proceeds, etc." (Section 6). Also, remittance of loan interest or return of loan principal to a special purpose company from any borrower in China is subject to compliance with generally applicable foreign currency borrowing procedures.¹⁷

Funds obtained by a resident from a special purpose company must be remitted back to China within 180 days. Once remitted, profits or dividends can be freely converted into renminbi or deposited in a current foreign currency account at the discretion of the receiving resident. Foreign revenues from capital changes, meanwhile, are subject to approvals before disposition (Section 6, paragraph 2).

SCOPE OF THE CIRCULAR - BROAD AND NARROW DEFINITIONS

Some of the Circular's definitions are very broad and inclusive, while others are stated in narrow and exclusive terms. "Control", for example, is defined in great breadth and detail as "the right to operate, the right to the benefits from, or the right to decide policies of a special purpose company or domestic enterprise obtained by a domestic resident through such means as an acquisition, trust, agency, voting rights, buyback, convertible bonds, etc." (Section 1, Paragraph 4).

The direct investment activities included in the definition of "round-trip investment" are also set out in great breadth and detail. They "include but are not limited to the following methods: purchasing or swapping for the equity of a Chinese shareholder/owner in a domestic enterprise; establishing a foreign-invested enterprise in China and through such an enterprise purchasing or reaching agreement to control domestic assets; purchasing through agreement domestic assets and using such assets to invest in and establish a foreign-invested enterprise or for increasing the capital of a domestic enterprise" (Section 1, Paragraph 2).

"'Control' is defined as 'the right to operate, the right to the benefits from, or the right to decide policies of a special purpose company or domestic enterprise obtained by a domestic resident through such means as an acquisition, trust, agency, voting rights, buyback, convertible bonds, etc'."

In contrast, the purposes included in the definition of a "special purpose company" appear relatively narrow and exclusive, including "conducting ... financing abroad [based on injected] domestic enterprise assets or equity" (Section 1, Paragraph 1). This wording appears to indicate that the Circular does not cover either (a) an offshore company that receives from residents only cash investments - as versus asset or equity injections - or (b) an offshore company that does not have the purpose of raising finance abroad.

It remains to be seen if SAFE will clarify whether or not these latter two types of offshore companies are covered under the Circular. For example, might uncovered types of offshore companies and their investors be able to engage in PRC transactions without handling SAFE registration under the Circular? Or - more likely - would the lack of SAFE registration under the Circular prevent uncovered types of offshore companies (if controlled by residents) from making investments or loans into China?

BACK TO MOFCOM - SHARE SWAPS; APPRAISALS

In respect of cross-border transactions by resident legal persons, the Circular can be seen in part as a return by SAFE to its historical role as the less visible and more procedure-oriented counterpart to the more visible and more policy-oriented MOFCOM.

Many months ago, MOFCOM informally circulated draft regulations that would recognize, permit and regulate cross-border equity swaps and similar transactions. But it appears that these regulations are unlikely to be finalized and issued until after this year. When eventually issued, such regulations will be an important step in enabling more flexible and sophisticated cross-border transactions and structures.

In the meantime, once SAFE begins completing registrations under the Circular, resident individuals will probably find it easier to participate directly in such transactions than to do so indirectly through domestic enterprises. Foreign investors, meanwhile, will find it quicker to co-invest with Chinese individuals than with Chinese enterprises, while deferring for now any cross-border equity swaps or similar transactions.

MOFCOM's next steps may also clarify the trend of government thinking on whether or not appraisal requirements should be imposed on transactions that do not include state-owned assets.¹⁸

'MOFCOM draft regulations [on] cross-border equity swaps [are] unlikely until after this year [This] will be an important step in enabling more flexible and sophisticated cross-border transactions and structures.'

TRENDS AND PROJECTIONS

After a 2004 surge in offshore listings and venture capital-style investments into China through offshore companies, often including round-trip investments, the first three quarters of 2005 have witnessed an abrupt drop-off. Assuming that the Circular is interpreted and implemented in a relatively investor-friendly manner, a strong rebound in activity is likely in 2006. Fundamental forces driving the long-term growth trend include the increasing internationalization of high-technology companies not only in China but also in many other countries and regions.

The Circular does not mark the final chapter in tension between the government's regulatory concerns and the preference of investors for flexibility, autonomy and privacy. Nevertheless, there are clear indications that China's policy-makers will continue working to develop a balanced approach in integrating offshore transactions into China's broader regulatory framework. The government now clearly welcomes a resumption of growth in regulated round-trip investments, offshore listings and other sophisticated cross-border financings of privately-owned enterprises.

Endnotes

1 This definition is quoted and discussed under the section headed 'Scope of the Circular - Broad and Narrow Definitions'.

2 This definition is also quoted and discussed under the section headed 'Scope of the Circular - Broad and Narrow Definitions'.

3 The Circular was issued October 21, 2005 and is effective from November 1, 2005.

4 There was no formal decision to implement a freeze, but transactions involving China resident individuals suddenly became subject to SAFE registration, which generally could not be accomplished in practice under existing regulations and policies of SAFE and the Ministry of Commerce.

5 The two repealed circulars had the effect of freezing progress on many pending venture capital transactions and most pending red-chip and other foreign listings. Their repeal has thus been widely celebrated.

6 Only after this registration can SAFE procedures be handled for a "related" (invested) domestic enterprise.

7 For completed round-trip investments, evidenced by completion of procedures for inbound investment into China (Instruction No. 1), the Circular has now provided the necessary details on procedures and documents, but has not yet dispelled the previous uncertainty about the breadth and strictness of scrutiny that will be applied. The Circular does not appear to allow supplementary handling of registration of any special purpose company that might have been established without completing a round-trip investment back into China.

8 This definition is quoted and discussed under the section headed 'Scope of the Circular - Broad and Narrow Definitions'.

9 Section 2, paragraph 4 and 5; lists of documents are summarized in the next endnote.

10 Submissions for this registration procedure must include (i) a written application with details of the domestic enterprise, special purpose company and overseas financing plans; (ii) individual identification document or enterprise registration document; (iii) offshore financing commercial plan; (iv) official reply approving source of foreign exchange funds or assets (only for a legal person domestic resident) and approval document from MOFCOM or its local delegated department; (v) a filled-out and signed form (for each resident individual - see details in the section headed 'Filing Form, Instructions & Disclosure Scope"), or an Overseas Investment Related Foreign Exchange Registration Certificate (for each legal person domestic resident); and (vi) "other true explanatory/evidentiary materials"(Section 2).

11 Submissions for this registration procedure must include (i) a written application detailing changes in shareholders and equity structure, and the method of pricing the assets or equity of the domestic enterprise and special purpose company; (ii) a filled-out and signed form (for each resident individual - see details in the section headed 'Filing Form, Instructions & Disclosure Scope'), or (for each legal person domestic resident) an Overseas Investment Related Foreign Exchange Registration Certificate; (iii) the round-trip investment approval document or recordal document from MOFCOM or its local delegated department; (iv) if state-owned assets are involved, a document from the State-Owned Assets Supervision & Administration Commission (SASAC) confirming the value of the domestic enterprise's assets or equity; (v) explanatory/evidentiary documents of the special purpose company, such as its overseas registration and filing (e.g., certificate of incorporation], business licence, etc.; and (vi) "other true explanatory/evidentiary materials" (Section 3).

12 Submissions for this registration procedure must include the same documents as under endnote 11 (ii), and the two submissions apparently can be consolidated into a single submission if the two transactions can be explained to SAFE at the same time (Section 3).

13 Other material changes include "a capital increase or reduction, equity transfer or swap, merger or division, long term equity or debt investment, etc". The required procedure is for "amendment of overseas investment related foreign exchange registration or recordal" (Section 7). The list of documents to be submitted for this procedure is not set out in the Circular.

14 Foreign direct investment into China requires MOFCOM approval and SAFE registration. Foreign loans to a foreign-invested enterprise require SAFE registration, while foreign loans to other domestic enterprises require SAFE approval.

15 Copies of the form and instructions (in Chinese) can be downloaded from the SAFE website.

16 The instructions along with the form appear to have been prepared by different drafters than the Circular itself, in view of various word substitutions such as "individual" in place of the more legalistic "natural person".

17 Foreign loans to a foreign-invested enterprise require SAFE registration, while foreign loans to other domestic enterprises require SAFE approval.

18 Historically, express requirements for appraisals to justify transaction prices were limited to state-owned assets. Recent M&A regulations, however, state that even privately-owned assets should be priced "on the basis of" appraisals when included in M&A transactions. See Article 8 of the Tentative Provisions for the Acquisition of Domestic Enterprises by Foreign Investors, issued March 7, 2003 by MOFCOM predecessor the Ministry of Foreign Trade and Economic Cooperation (MOFTEC), the State Administration of Taxation (SAT), the State Administration of Industry and Commerce (SAIC) and SAFE. This statement has drawn much attention from foreign investors and commentators concerned about an apparent move to increase government regulation of private asset valuations. But a move back towards reducing government regulation on this point may be suggested by the Circular's express requirement - in respect of state-owned assets - of a State-Owned Assets Supervision & Administration Commission of the State Council (SASAC) value confirmation document (which is normally based on an appraisal), without any mention of equivalent documents in respect of other non state-owned assets (Section 3, paragraph 4).