By Michelle Tzhori and Vincent Zhang

On January 19, 2015, China’s Ministry of Commerce (“MOFCOM”) released the draft Foreign Investment Law for public comments (the “Draft Law”).The deadline to submit comments is February 17, 2015.

The Draft Law proposed fundamental changes to the existing foreign investment legal regime in China and has a profound impact on both existing and future investments. We hereunder summarize some highlights of the Draft Law.

National treatment to foreign investment

Currently China maintains a restrictive foreign investment regime, under which all foreign investments are subject to various government approvals, such as the approval of the foreign investment authority (i.e. the MOFCOM or its local branches) or industry-specific approvals from relevant regulators, e.g. food and drug administration. In practice, the local government authorities at different levels may apply different criteria, requirements and considerations while reviewing and determining foreign investment applications. Lack of clarity in the foreign investment approval process has created market access obstacles and other challenges for foreign investors.

The Draft Law introduces the principle of “national treatment” to foreign investors during the market-entry phase, by removing the foreign investment approval process. The draft Law employs a “negative list” approach in which, unless a foreign investment falls within the “negative list”, foreign investors may invest in China on the same terms as Chinese domestic investors, without being subject to additional approvals or industry-specific restrictions.

Negative List

The Draft Law proposes a Negative List (formally named as “Catalogue of Special Regulatory Measures on Foreign Investment”) that will be formulated by the State Council to consolidate the requirements and restrictions posed on foreign investment into one catalogue. Foreign investors will be allowed to invest in sectors, which are not included in the “Negative List”, without any approval requirements or other restrictions, such as the requirement for joint venture with domestic partners.

The Negative List comprises two parts: (1) Prohibited Investment List which will set out the industries closed to foreign investors, and (2) Restricted Investment List which will set out specific restrictions for foreign investment, including: (a) investments which exceed investment amount limits prescribed by the State Council, or (b) investments in certain restricted sectors. Foreign investment in those sectors on the “Negative List” must satisfy the conditions in the “Negative List” and obtain foreign investment approvals.

The Negative List approach is not new in China. It was firstly introduced in the Shanghai Pilot Free Trade Zone (FTZ) in September 2013 with the initiative to liberalize the trade and investment administration. The latest version of Shanghai FTZ Negative List was issued in July 2014, which reduced the number of prohibited/restricted sectors by 51 (from 190 to 139).

National Security Review

Chinese government authorities have been monitoring foreign investment concerning national security for many years. A formal national security review system relating to foreign acquisitions of domestic enterprises was put in place in 2011. The Draft Law incorporates the previous national security review system, and expands the national security review to any foreign investment that damages or may potentially damage national security, regardless of the industry sector and not limited to acquisitions. A national security review can be launched following an application by the foreign investor, or initiated by relevant government agencies, industry associations, competitors or upstream and downstream businesses.

According to the Draft Law, a joint committee for national security review will be formed under the State Council, including without limitation members from MOFCOM and National Development & Reform Commission. Determining whether a foreign investment damages the national security requires the joint committee to weigh a variety of factors, e.g. impact on products, services required for national defense etc.

Unified application of the Company Law to foreign investment enterprises

The Draft Law, once effective, will repeal the three core foreign investment laws still in effect today, i.e. the Sino-foreign Equity Joint Venture Law, the Sino-foreign Cooperative Joint Venture Law and the Law on Wholly Foreign-owned Enterprises (collectively “Foreign Investment Laws”).

The Foreign Investment Laws were promulgated around 30 years ago and were lastly amended in 2000 and 2001. According to the Foreign Investment Laws, foreign investment enterprises are subject to special organizational and other requirements. For example, under the Sino-foreign Equity Joint Venture Law, the highest decision-making authority of an equity joint venture company shall be the board of directors, rather than the shareholders’ meeting and the unanimous approval of the board of directors is required for changes in the registered capital, liquidations and amendments to the articles of association.

The Company Law of China was enacted in 1993 as the basic law to regulate the incorporation and management of companies in China. Since then there coexist two regulatory systems for foreign investment enterprises, one being the Company Law, and the other the Foreign Investment Laws together with various regulations and implementing rules, which prescribe special organizational and other requirements for foreign invested enterprises. However, the Company Law has undergone a number of amendments, the most recent amendment which took effect on March 1, 2014, reformed the long-standing registered capital requirements and simplified the requirements and process for establishing a company in China. Thus, the differences between the two regulatory systems become significant and their coexistence and application to foreign investment in practice are controversial.

After the abolishment of the Foreign Investment Laws and the old regulatory regime, it is expected that the application of the Company Law and other foreign investment regulations will be harmonized. The Draft Law does not contain provisions to regulate the corporate forms of foreign-invested enterprises, which means that the Company Law will be applied to both foreign invested companies and domestic companies in terms of incorporation, corporate governance, liquidation and other corporate matters.

New information disclosure requirements for foreign investment

The Draft Law provides for a new reporting regime under which foreign investors and foreign invested enterprises shall disclose relevant information on a regular basis.

The following reporting is required under the Draft Law:

-     Initial report: before the establishment/implementation of a foreign investment or within 30 days after its establishment/implementation.

-     Material changes report: within 30 days after such material changes, e.g. change of investor’s name, change in the amount of investment, transfer of the beneficiary interests in the investment, liquidation and winding-up.

-     Annual report: The Draft Law requires a foreign invested company to submit an annual report to the foreign investment authority (or a quarterly report for large-scale foreign investment enterprises). The information contained in the annual report seems extensive and burdensome, such as the foreign invested company’s main products/services, import/export, employment, financial status, transactions with its affiliates, material disputes.

The reporting is to be made through the foreign investment information reporting system to be established by the foreign investment authority. Failure to make such reporting timely or any concealment in such reporting may result in fines or other regulatory sanctions. Information contained in the above reporting will be made publicly available, except for matters involving trade secrets or privacy of individuals.

VIE structure to be regulated

The Draft Law and its explanatory notes have, for the first time, unveiled three possible approaches to regulate the VIEs.

VIEs, which stand for “variable interest entities” are investment vehicles used by foreign invested entities to control a Chinese domestic operating company through a series of contractual arrangements, rather than through equity ownership. For more than a decade, VIEs have been used by a number of foreign companies to indirectly invest in China’s restricted and prohibited industries (e.g. telecom, education), and widely used by Chinese domestic companies publicly offering and listing in offshore stock exchanges, notably SINA, Alibaba and other “.COM” companies listed in NASDAQ. However, though no regulatory actions have been taken against the VIE structures, VIEs are deemed a circumvention of laws and regulations and the validity and enforceability remain unclear.

The Draft Law provides that an investment in the form of “contractual control” (the inherent feature of the VIE structure) by foreign investors will be regulated as foreign investment. Any further investment through “contractual control” will need to comply with the new foreign investment regime. In terms of the treatment of existing VIE companies in restricted and prohibited industries, the explanatory notes propose three options for public consultation and further review:

-     Reporting: the parties report to the foreign investment authority and declare the actual control by Chinese investors, and the VIE structure can remain and continue its operation;

-     Applying for recognition: the parties apply to the foreign investment authority for the official recognition of the actual control by Chinese investors, and if recognized, the VIE structure can remain and continue its operation;

-     Applying for market entry permit: the foreign invested company should apply for and obtain the relevant market entry permit in order to continue its operation.

Among the three options above, the first “reporting” is more favorable to the VIEs, but the third one “applying for market entry permit” will be a very harsh approach.

Implications for Existing Foreign Investments

The Draft Law allows the existing foreign investment companies to continue operating under their prior approvals (e.g. business scope, term of operation). But they should review their existing corporate forms for any non-compliance and within a three-year transition period, convert its corporate forms into a corporation or partnership under the Company Law or relevant regulations. For example, equity joint companies will be required to form a shareholders’ meeting to comply with the Company Law requirements.

The Draft Law signals Chinese government’s continued efforts to boost the inbound foreign investment by removal of major hurdles for foreign investment over the past 30 years. If it receives legislative approval, it will bring a high degree of flexibility for foreign investors. As a common practice, the Draft Law will be further reviewed and amended by various government authorities, then submitted to the National People’s Congress for legislative approval, so there is no indicative timeline when the Draft Law will take effect.

We will continue to monitor any upcoming development on the Draft Law and keep you posted.