China revamps foreign investment rules, tackles VIEs

The Ministry of Commerce's draft PRC Foreign Investment Law, released on January 19 for public comment, expands the definition of “investment” and unifies and repeals the three current foreign-invested enterprise (FIE) laws: the PRC Wholly Foreign-owned Enterprise Law (Revised), the PRC Sino-foreign Equity Joint Venture Law (2nd Revision) and the PRC Sino-foreign Cooperative Joint Venture Law (Revised), which govern the corporate structures of foreign entities in China.

Once the new Foreign Investment Law is in effect, all entities – both domestic and foreign – will have to apply the PRC Company Law to their structures. The draft is open for comments until February 17 2015.

“An interesting development is that the law will treat FIEs actually controlled by Chinese investors as Chinese companies in terms of approval and registration,” said Wenfeng Li of Weil Gotshal & Manges. “We'll have to see how supporting regulations will treat FIEs controlled by foreign investors in comparison, with respect to market entry and other regulations such as environmental protection, foreign exchange and international trade.”

Solving the VIE puzzle

The overhaul includes proposals to consolidate previous laws, treat overseas and domestic companies equally and address the issue of structures long used to bypass ownership restrictions.

The draft sets several precedents by specifically addressing variable interest entity (VIE) structures for the first time in writing and introducing the concept of actual control.

“The law provides that authorities will focus on substance over form of entities and differentiates between VIEs ultimately controlled by Chinese investors and those controlled by foreign investors,” said Michael Han of Fangda Partners.

MOFCOM has provided three options in its Explanatory Notes for dealing with existing VIEs:

1. The companies report to MOFCOM that they are ultimately owned by Chinese investors, and may retain their structures and continue operations;
2. They apply to MOFCOM stating that they are ultimately owned by Chinese investors, and can retain the structures and continue their operations only after receiving approval; or
3. The companies apply to MOFCOM, which reviews the applications with other regulatory departments and decides whether to grant approval based on its consideration of the actual controller of the entity.

The last option leaves the door open for entities with foreign investors as the controlling shareholders to apply for approval.

“The first option is most friendly to Chinese investors who have used the VIE structure in offshore financing, while the third is most uncertain due to a lack of transparency in the review process and criteria,” said Li. He believes the third choice is unlikely to go through as the current trend in reforming the legal regime for foreign investment is deregulation.

Some observers have questioned whether VIEs will need to restructure or, in the case of e-commerce businesses, relocate to the Shanghai Free Trade Zone (FTZ), but Michael Tan of Taylor Wessing doubts whether these are viable. “Reorganising may hurt innocent investors,” he said, adding that “In the end, it's also a cost issue. Can the operation survive after a complete restructuring?”

While the government will be strict in implementing the new law, it may not be too harsh because that could chase away famous brands and dent the country's image as an investment destination. This is likely, considering that China currently tolerates VIEs, said Tan, adding that he expects more disputes to arise because the new law will dilute minority protection.

While regulators will no longer permit the existence or formation of new investments through VIEs controlled by foreign investors, the new law may make some exceptions or have grandfather provisions for regulators to make case-by-case decisions.

There is already a precedent in the online video sector. New regulations required these companies to be majority-owned by state-owned companies, but they contained a grandfather provision that allowed existing, wholly privately-owned corporates to continue operating after renewing their permits.

Challenging scenarios

In general, the changes are good for international investors which have participated in restricted industries using the VIE structure, said Weil's Li, adding that, in most cases, foreign investors are not controlling shareholders in the offshore financing and IPOs of Chinese companies (though exceptions include take-private transactions).

“But what happens if a foreign company or consortium of foreign investors take control of the Cayman holding company that controls the domestic operating company through the VIE structure? This would be an interesting and challenging issue for both regulators and companies. What steps should regulators take to deal with this and what should the company do to comply with market entry rules after the acquisition?” he said.

Negative list

The new law will be accompanied by a negative list, which acts as a hurdle for market entry clearance. A foreign investment proposal will have to apply for approval only if it is involved in a sector on the list – all others are permitted and only required to record-file as well as submit information reports.

“If it isn't on the negative list, a foreign entity can set up a business practice in China just like any domestic company,” said Han. He wondered, however whether foreign entities will really receive equal treatment in practice.

Li believes the list will be much friendlier to foreign investors than the current Foreign Investment Industrial Guidance Catalogue that it replaces. “The point is to reduce unnecessary approvals for inbound investment and only retain the approval process for critical industries,” he said.

“The attempt to produce a national-level negative list is correct,” said Tan of Taylor Wessing. “The existing negative list of the Shanghai FTZ does not actually touch upon investment access, only the procedural aspect. A negative list under national law will be much more comprehensive and relevant.”

The draft also incorporates a chapter on national security reviews, elevating the process from departmental regulations to official law. It states that foreign investments that raise national defence concerns are subject to review, decisions of which cannot be appealed. The expanded scope of review and the lack of clarity on standards may cause some concern for foreign investors.

Remaining obstacles

One area the draft does not touch upon is foreign exchange rules that are specific to FIEs. “Foreign companies have to undergo a special registration process with SAFE [State Administration for Foreign Exchange] to open foreign exchange accounts. This is different to the process for purely domestic companies, which are not allowed to open capital accounts unless they are engaged in outbound acquisitions. We'll have to see how these other regulations will change,” said Li.

Another big challenge lies in the transition into the new regulatory regime. FIEs are provided a three-year transition period to make the changes to their legal form and corporate structure. But until completion, the three FIE laws will still apply. The draft does not explain how long-term financing and real-estate transactions that fall within the scope of the new law will be treated during the transition period, according to a King & Wood Mallesons report.

“This law will open more industries to foreign investment, but there is a need to tighten real enforcement,” said Han of Fangda Partners. “The current problem is that everything is subject to approval but investors find a way to circumvent the process. The point of this law is to make it easier to invest but at the same time tighten supervision.”


By Katherine Jo