Roundtable Discussion China Proposes a New Foreign Investment Law: - - PowerPoint PPT Presentation

Roundtable Discussion China Proposes a New Foreign Investment Law: Does this Represent the Death of the VIE Structure?

Brinton Scott, Matthew Durham

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Draft Law Proposed

• On 19 January 2015 the PRC Ministry of Commerce released a

preliminary draft of a proposed new Foreign Investment Law and a corresponding Explanatory Note for public comment—the public comment period expired on 19 February 2015.

• If promulgated in its current form the Draft Law would represent

a major shift in China’s foreign investment regime.

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Main Highlights of the Draft Law

• Unifies Current Foreign Investment Laws
• Creates a Negative List to Replace the FDI Catalogue
• Foreign Control Through a VIE Structure Will Be Treated the

Same as a Foreign Direct Investment

• Potential Impact on Existing Companies

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• 1. Unification of Foreign Investment Laws

Unification of Foreign Investment Laws

• The Draft Law would replace the three main current foreign

investment laws:

• Wholly Foreign-Owned Enterprise Law,
• Sino-Foreign Equity Joint Venture Law, and
• Sino-Foreign Cooperative Joint Venture Law.
• Under the Draft Law, a single, unified body of foreign investment law

would govern all foreign investments in China.

• "The State adopts a unified foreign investment management regime." Article

5, The Draft Law.

• "Foreign investors shall enjoy national treatment when investing in Mainland

China, unless otherwise prescribed by the Catalogue of Special Management Measures for foreign investment . . ." Article 6.

Potential Impact: Foreign and domestic investors would, with certain limitations, be treated virtually the same when investing in the PRC.

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• 2. Negative List Replaces the Catalogue

Negative List Replaces the Catalogue

• Under the current legal regime, in order to establish a new

business in China, foreign investors must:

• First determine how a proposed project is categorized by making reference

to the Foreign Investment Industry Guidance Catalogue (the "Catalogue");

• then, generally (depending on the specific industry sector) apply to MOC

and the National Development and Reform Commission (the "NDRC") for approval; and

• once approved, apply to the relevant office of the State Administration of

Industry and Commerce ("SAIC") for the new entity’s business license. Note: The Catalogue lists areas into which foreign investment projects are "encouraged," "restricted," or "prohibited." Foreign investment projects not listed in the Catalogue are generally considered to be "permitted" and will likely receive approval. On the other hand, if a project is "restricted" or "prohibited," then it is unlikely to be approved barring special circumstances (e.g. a minority joint venture arrangement).

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Negative List Replaces the Catalogue

• The Draft Law, instead, adopts a "negative list," which will be

published by the State Council at a later date and will replace the Catalogue. Key points include:

• The negative list will set out industries where foreign investment

is "restricted" or "prohibited" only and, in some industries, specific investment amount thresholds.

• Restricted Projects: Like the current legal regime, pre-approval will be

required for "restricted" projects – application to receive "market entry licensing" from the relevant competent foreign investment department.

• Non-Restricted Projects: Unlike the current legal regime, NO pre-approval or

market entry licensing will be required for foreign investors setting up projects that are not on the negative list.

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Negative List Replaces the Catalogue

• Instead, these foreign investors need only submit an investment

information report to a "foreign investment information reporting system" within 30 days after the completion of the investment transaction.

"A foreign investor or foreign-invested enterprise shall submit information reports in accordance with this Section prior to the investment or within 30 days from the date of investment." Article 85.

Potential Impact: Procedurally, setting up foreign investment projects which are not "restricted" should be significantly more efficient than under the current legal regime - since no pre- approval will be required.

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• 3. Foreign Control Through a Vie Structure

Will Be Treated the Same as a Foreign Direct Investment

Foreign "Control" Through a Vie Structure = Foreign Direct Investment

• Under the current legal regime, foreign investors wishing to

invest in the "restricted" category have often times employed contractual and other mechanisms (e.g., share pledges, voting proxies, management contracts, and so on) to allow them to gain indirect control over the Chinese entity.

• These structures usually involve a special vehicle set up in China (e.g., a

consulting wholly foreign owned entity) for these purposes.

• These "controlling entities" are generally known as variable interest entities

("VIEs") and have been adopted by many companies (both public and private) located outside of China.

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The Variable Interest Entity

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Foreign "Control" Through a Vie Structure = Foreign Direct Investment

• Current PRC laws do not directly address VIE structures
• The Draft Law would recognize VIE structures and focus on

substance over form going forward so that:

• Chinese companies which are directly or indirectly "foreign controlled” by an
• ffshore investor (i.e., via a VIE structure) will be treated as "foreign

invested,” and

• This would subject certain of these types of investments to an examination

and approval regime similar to that which presently exists under the FIE laws.

• The Draft Law does this by first defining “foreign investors” and

“foreign investment” and then defining “control”

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Foreign "Control" Through a Vie Structure = Foreign Direct Investment

• “Foreign Investors” would be defined as:
• Natural persons who do not hold Chinese nationality;
• Enterprises established pursuant to the laws of other countries or regions;
• Governments of other countries or regions and their subordinate departments or

agencies; and

• International organizations.
• “Foreign Investment” would be defined as, inter alia, any of the

following investment activities by a foreign investor:

• The establishment of an enterprise in China;
• The securing of shares of, equity in, a share of the property of, voting rights in, or
• ther rights or interests in, an enterprise in China;
• The provision of financing with a term of at least one year to an enterprise in China in

which a foreign investor holds rights and interests as specified in the preceding item; and

• Control (emphasis added) of an enterprise in China or the holding of rights and

interests in China by virtue of a contract, trust, etc.

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Foreign "Control" Through a Vie Structure = Foreign Direct Investment

• “Control” of a Chinese entity by a [“Foreign Investor”] for the purposes
• f the Draft Law means any of the following (Article 18):
• A [foreign investor] directly or indirectly holds 50% or more of the company’s shares,

equity, property shares, voting rights, or other similar rights and interests of the enterprise;

• A [foreign investor] directly or indirectly holds less than 50% of the company’s shares,

equity, property shares, voting rights, or other similar rights and interests of the enterprise BUT:

• Can directly or indirectly appoint at least half of the board or similar decision-making body,
• Can ensure that at least half of the board seats are taken by its nominated persons, or
• Its voting rights are sufficient to exert a material impact to the resolutions of the board, general,
• r shareholders’ meeting; or
• A [foreign investor] is able to exert decisive influence on the operations, finance,

personnel, technology, etc. of the enterprise through contracts, trusts or other means.

• “De Facto Control” means ANY enterprise (Chinese or foreign) under the direct or

indirect control of foreign investors or foreign-invested enterprises (Article 19).

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Foreign "Control" Through a Vie Structure = Foreign Direct Investment

• This means that if a Chinese entity—which operates in a

restricted or prohibited area—is effectively "controlled" by a foreign entity through a VIE structure after the Draft Law is promulgated, then the MOC may treat the target entity as a foreign direct investment and subject it to the approval/market entry licensing process noted in the next slide.

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Foreign "Control" Through a Vie Structure = Foreign Direct Investment

The Note offers the following three possible approaches for existing VIEs which operate in the “Restricted” or “Prohibited” sectors:

• 1. If a Chinese investor actually has "control" over the Chinese entity which is

the subject of the VIE structure, then the arrangement may continue after that entity files a statement with the foreign investment department that it is "Chinese-controlled"; or

• 2. If a Chinese investor actually has "control" over the Chinese entity which is

the subject of the VIE structure, then the arrangement may continue after that entity applies for a confirmation from the foreign investment department that in fact the entity is "Chinese-controlled"; or

• 3. If, on the other hand, the VIE structure is controlled by a foreign investor,

then the VIE must apply for "access permission" and the foreign investment department will decide whether to allow the VIE structure to continue to exist based on an "overall consideration [of the facts including who actually controls] the foreign investor [in the VIE structure] and other elements."

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Foreign "Control" Through a Vie Structure = Foreign Direct Investment

The Draft Law will treat the “Restricted” and “Prohibited” sectors as follows:

• Prohibited: Foreign Investment will not be allowed. The Foreign

Investment may not continue.

• Restricted: May be allowed—but, only in compliance with the

provisions of the Negative List or other applicable laws and regulations (e.g. If “control” is not allowed, than an existing VIE would need to be restructured so that it would ultimately become compliant with the Draft Law) The MOC has offered the following further explanation in the Note: only VIE structures with Chinese-controlled investors will be allowed to continue to operate with their existing structures.

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• 4. Potential Impact: Existing VIES May Be

Illegal

Potential Impact: Existing VIES May Be Illegal

• Potential Impact: The Draft Law could have a profound impact
• n investors that have relied on VIE structures as a part of their
• verall business if an existing VIE structure is suddenly deemed

"invalid" or "illegal”:

• Share values could plummet;
• Investors may cease operations in China;
• Layoffs and closures could be imminent.

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• Restructuring (if deemed restricted)
• Company closure and liquidation (if prohibited)
• Employment issues
• Cost
• Ongoing administration
• Media issues

Potential impact

Restructuring

• Does it make sense to restructure?
• Need to obtain regulatory approvals for changes
• What will the new business scope be?
• Time and cost
• Employment issues

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• Time-consuming process – 12 months absolute minimum,

normally longer (18 – 24 months)

• Liquidation committee
• Filings with multiple regulators – MOFCOM, SAIC, Tax Bureau,

SAFE, Customs, Labor Bureau

• Full tax audit – minimum 3 years, but potentially for entire

history of company

• Any irregularities may lead to delays and penalties
• Important to maintain some knowledge of company operations

(especially finance) to answer questions from regulators

• Overall expense – administrative, legal and accounting fees,

employment costs

Closure and liquidation process

Shutdown of Existing Companies in China is Not Easy – Labor Issues

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• Termination or transfer
• Transfer requires consent of each individual employee
• Termination requires an express ground prescribed by law:
• Company closure
• Mass lay-off due to major change – requires a consultation process with

ALL employees and filings with labor bureau

• Severance is required for termination (and employees may

request this as a condition to transfer)

• Time–consuming process – documents, communications with

employees and filings with regulators

• Communication is critical – risk of unrest (increasing trend)
• Adverse media coverage and reputation risk

Employee issues

Q&A