What the foreign investment overhaul means for investors

On January 19 2015, China's Ministry of Commerce (MOFCOM) released for public comment a draft PRC Foreign Investment Law (中华人民共和国外国投资法 （草案征求意见稿）) (FIL), along with accompanying Explanatory Notes (Notes).

The draft FIL represents a paradigm shift in China's approach to the regulation of inbound foreign investment. It contemplates the elimination of the current foreign investment approval regime and, with it, the equity joint venture, the cooperative joint venture and the wholly foreign-owned enterprise, historically the three main corporate vehicles for foreign investment transactions. In place of the current approval regime, the draft FIL provides for a more limited regulatory approval requirement applicable only to projects of a size and in sectors stipulated in a negative list, adopting an approach that was first implemented in 2013 on a pilot basis in the Shanghai Free Trade Zone. Assuming the law in its final form reflects this same approach, the FIL should streamline regulatory formalities applicable to foreign investment transactions and, depending on what the negative list ultimately includes, result in further opening of the Chinese market to foreign investment.

That said, the draft FIL also includes a number of potentially onerous provisions for foreign investors, including a burdensome reporting system to govern cross-border investments and an expanded national security review process for foreign investments.

Regulating VIEs

Perhaps the most widely-discussed aspect of the draft FIL is its impact on variable interest entity (VIE) structures. The VIE structure has been used extensively to facilitate offshore financing of Chinese businesses in the TMT and other sectors subject to foreign investment restrictions and has also been used by foreign strategic investors to make indirect investments in these same sectors. This has been feasible because existing foreign investment regulations consider only the jurisdiction of incorporation (or nationality) of the direct shareholder of the captive domestic entity that serves as the VIE and disregard arrangements that allow de facto control of the businesses through the contractual arrangements utilised in a VIE structure.

The FIL changes this, drawing VIE structures clearly within its ambit. It does so both by focusing broadly on “control” of a domestic enterprise and by expressly including “arrangements that effect control of a domestic enterprise through contracts, trusts and other means” within the definition of foreign investment. As a result, if the FIL is promulgated in its current form, VIE-structured investments will be subject to the same regulatory oversight as direct foreign investment transactions and use of a VIE structure will no longer permit investors to circumvent foreign investment rules.

Negative list

Almost inevitably, the FIL represents a clampdown on foreign investment into many of the sectors where VIE structures have been widely used in the past. The extent of the clampdown depends on what the to-be-promulgated negative list stipulates.

Taking account of the liberalisation of foreign investment restrictions applicable to e-commerce and other sectors under the Shanghai Free Trade Zone's own negative list, most commentators are optimistic that the list under the FIL will reflect a loosening of foreign investment restrictions in a number of those sectors as well as permit foreign investments in them without the need to use a VIE structure or obtain approval.

Nonetheless, in the sectors that do make their way onto the negative list, a VIE structure would no longer facilitate foreign acquisition of a controlling interest in a Chinese enterprise. Depending on the specific stipulations of the negative list, the acquisition will either not be feasible or at least be subject to the foreign investment approval process provided for under the FIL.

Minority investments

At the same time, the FIL ought to be welcomed by foreign investors interested in acquiring only minority non-controlling stakes in businesses which are in industry sectors subject to foreign investment controls. Since negative list-driven controls under the FIL are triggered by the acquisition of foreign control of a Chinese enterprise, foreign acquisition of a minority interest in an enterprise that remains subject to the control of Chinese shareholders will be feasible without requiring approval under the FIL, even if the enterprise operates in a sector named on the negative list.

Handling existing VIEs

Given the large number of VIE-structured Chinese businesses listed on the US and other international securities exchanges, the most controversial issue regarding the FIL is the likely fate of existing VIE investments.

Article 158 of the draft FIL entitled 'Handling of Control by Agreement' includes only a cross-reference to the Notes. The Notes in turn make clear that MOFCOM is still in the process of evaluating possible approaches to handle existing investments that have utilised contractual control structures. They also identify a number of these approaches, including permitting any Chinese business to continue to operate using the structure if it can demonstrate in a certification or approval process that the business is subject to de facto control of Chinese investors and possibly subjecting other businesses to review on a case-by-case basis.

The FIL is still in the early stages of the legislative process. It will be important to monitor changes to the draft as the process unfolds.

Paul McKenzie, Beijing and Shanghai, and Thomas Chou, Hong Kong, Morrison & Foerster