Updates on foreign investment in China (part 1)

Updates on foreign investment in China (part 1) – China’s new Foreign Investment Law enters into force 1 January 2020

On 15 March 2019, China’s National People’s Congress passed the new Foreign Investment Law (FIL), which entered into force on 1 January 2020. It will repeal the three laws currently regulating foreign invested entities (FIE); namely the Sino-Foreign Equity Joint Venture Law, Sino-Foreign Cooperative Joint Venture Law (JV laws) and the Wholly Foreign-Owned Enterprise Law (WFOE law), collectively the ‘FDI laws’. Once in force, the new FIL will apply to all FIEs and is expected to have significant impact on their corporate governance structure.

Additionally, in June 2019 China released its updated Negative List setting out in which industries investment is prohibited or restricted, as well as its Encouraged Catalogue listing activities and sectors wherein foreign investment is encouraged. While these developments collectively have been welcomed as a signal of China’s efforts to encourage and protect foreign investment, foreign investors need to consider the impact of these changes on their investments. This article provides an overview of the new FIL, and addresses its impact on foreign investors. Part 2 provides an overview of the 2019 Negative List and Encouraged Catalogue, and will consider what these developments mean for foreign investors.

 

Overview of the FIL    

From 1 January 2020, the existing three FDI laws will be replaced by the new FIL. It provides that the organisation and governance structures of FIEs will be subject to China’s Company Law. Subsequently, the State Council promulgated the Regulations of the People's Republic of China on the Implementation of the Foreign Investment Law on 26 December 2020, which also entered into force from 1 January 2020 (Implementation Regulations).Pursuant to the “grandfather” clause in the new FIL, existing FIEs may keep their current structure for a period of 5 years after entry into force.

The new FIL applies to all investment activities conducted directly or indirectly by foreign natural persons, enterprises or organisations. The regulation list foreign-funded enterprises, foreign investors acquisition of shares and equities, and investments made to initiate new projects within China as examples of foreign investment. The FIL sets out a number of provisions aimed at promoting and protecting foreign investment, including

  • allowing FIEs to participate in government procurement projects through fair competition,
  • providing equal treatment to investments in sectors outside the ‘negative list with respect to licenses and market access,
  • allowing public offering of shares,
  • allowing foreign investors to remit profits, capital gains, royalties etc.

In addition, the FIL requires the State to respect the IP rights of foreign investors, and requires administrative bodies and officials to keep trade secrets confidential. It further prohibits compulsory technology transfers by administrative means. The new FIL also requires that a complaint mechanism is established to which foreign investors can submit complaints over infringements by government authorities and officials. Similarly, it will be possible for foreign investors to request administrative review and initiate administrative litigation.

Although the FIL is a positive step towards concrete protection and promotion of foreign investments, lack of clear details cause some uncertainties. Therefore, the Implementation Regulations step in to supplement. For instance, under the previous FDI laws, natural Chinese persons are prohibited from establishing EJVs and CJVs with foreign investors. Under the FIL, foreign investments can be made by a foreign investor jointly with “any other investor”. It is clearly indicated in Article 3 of the Implementation Regulations that Chinese persons are also included in the definition of “any other investor”. However, certain questions still remain unanswered, for instance, there is no definition of “indirect investment”, which is important for the determination of the ‘negative list’; the FIL and the Implementation Regulations are furthermore silent on whether domestic enterprises controlled by foreign investors through a variable interest entity structure (VIEs) fall within “foreign investor.

The FIL also establishes a foreign investment reporting system, but it does not include provisions on record filing in sectors outside the ‘negative list’. Foreign investments may further be subject to review on the grounds of national security. However, it remains unclear on which basis it is determined if an investment is “likely to affect national security”, as well as whether the referenced national security review system is the same as the current review system or if a new system will be established and perhaps replacing the current one. The Implementation Regulations do not provide elaborations on such topics and we are expecting that future legislations will provide further clarities on those unclear points.

 

Impact of the new FIL on FIEs

The new FIL repeals the current laws governing foreign-invested enterprises, and instead provides that these will be governed by the Company Law. Considering that WOFE’s have been subject to the Company Law since 2006, it is expected that this change will have little impact on these. For JVs, however, the FIL is expected to have significant impact due to the substantial differences between the JV laws and the Company Law regarding concerning organizational- and governance structure. For example, the highest governing body under the JV laws is the board of directors, whereas it is the shareholders meeting under the Company Law.

The appointment of directors is also different under the Company Law. While the number of directors to be appointed by each shareholder is normally determined in proportion to each shareholder’s capital contribution under the JV laws, the Company Law provides that the number of directors to be appointed can be stipulated in the AoA. Further, the statutory quorum under the JV laws is two thirds of all directors, whereas this is determined by the number stipulated in the AoA under the Company Law.

Moreover, the JV laws provide that decisions concerning amendments to the AoA, increase or decrease of registered capital, mergers/divisions and termination or dissolution require unanimous approval of the present directors. However, under the Company Law, these decisions instead require the approval of two thirds of the shareholders holding voting power. In regards to the distribution of dividends, the shareholders are similarly given more flexibility in deciding under the Company Law. The JV laws provide that dividends are to be distributed in proportion to the capital contribution of each shareholder. Although this is also the default position under the Company Law, shareholders may nevertheless decide on a different scheme by unanimity.

There are also significant differences concerning the transfer of shares. Under the JV laws, a shareholder intending to transfer its shares must obtain the consent of all other shareholders, regardless if it is an external or internal transfer. The other shareholders furthermore have a pre-emptive right. Under the Company Law, consent is not required for internal transfer of shares. As for external transfers, the transferring shareholder must obtain the consent of more than half of the other shareholders. If consent is refused, the dissenting shareholders have an obligation to purchase the shares. Dissenting shareholders that also refuse to purchase the shares will however be deemed as consenting to the transfer. If consent is obtained from more than half of the shareholders, then the shareholders have a pre-emptive right to purchase the shares on the same terms. In addition, the Company Law allows shareholders to agree on a different scheme for transfer of shares, in contrast to the JV laws.

Under the FIL, there is furthermore no requirement that foreign shareholders shall normally hold at least of 25% of shares. Under JV laws, if shareholders held less than 25% of the shareholding, then the foreign investors were not eligible for preferential treatment for FIEs. While FIEs have been subject to the same tax as domestic companies since 2008, in practice the 25% rule is still normally treated as minimum requirement for foreign investors. Foreign investors interested in minority shareholding will therefore benefit from this change.

 

What do these changes mean for joint ventures

With the new FIL, foreign investors need to assess the impact of these changes to their joint ventures. It may be necessary for the joint venture parties re-negotiate and determine how their joint venture agreements should be adjusted in response to these changes, particularly with regard to the corporate governance structure. Similarly, for new joint ventures that expect to be established prior to 1 January 2020, parties should already now consider the coming changes and take these into account in their agreements. 

For more information please contact our China Practice Mr Job Bezemer (jbz@kneppelhout.nl) and Mr Victor Zheng (vz@kneppelhout.nl)