23 January 2015

China breaking down the walls - Revolution in foreign investment planned

by Xu Ping, Mark Schaub and Jennifer Yao*

China is re-thinking how it deals and interacts with foreign investment. The publishing of the Draft Foreign Investment Law (“Draft FIL”) for public comment on 19 January 2015 was to announce that China was planning a foreign investment regulatory re-boot.  

However, it would be wrong to look at the Draft FIL in isolation. There is little doubt that the Draft FIL is another strand of the larger trend by which the Chinese government is transforming its role in the economy, cutting red tape and simplifying the administration of companies. 

China is not the same country it was when the first Sino-foreign Joint Venture Law was promulgated in 1979.  In those days China was hungry for technology, investment and economic growth. Today China has a slew of hi-tech companies and is innovative in many cutting edge technologies such as e-commerce, super-computers, smart phones, etc. Its rapid growth and developing economy has led to strong and sustained growth in outbound investment. In 2014 China changed from being a country of net capital inflow to one of net capital outflow. 

Despite these changes China’s current foreign investment regulatory framework has not kept pace with change and is largely been kept in place for the last 30 years. The main intention of the original raft of laws was tight control over both the entry and influence of foreign capital into China. Accordingly each and every foreign investment project requires approval by the Chinese authorities. However, as China has increasingly globalized and as foreign investment has changed from being a “one way street” to “two way traffic”, China has increased in confidence and also changed its mindset. Indeed, the new reforms foreshadowed by the Draft FIL may be a “velvet revolution” – in that the reforms illustrate both China’s confidence in dealing with foreign investment and also her emergence as a global economy that is willing to play by global rules. 

Draft FIL – One law to govern all

The Draft FIL is intended to replace the piecemeal regimes set out under numerous existing laws and regulations relating to various forms of foreign invested enterprises (FIEs). In this regard the FIL will provide a uniform foreign investment regulatory framework which aligns with common international practice. This represents a very significant step in the direction of liberalization. 

The current foreign investment regime foresees involvement by the authorities’ in every stage of the foreign invested enterprise’s (“FIE”) life cycle - from cradle to grave. The FIL would replace the old system with a much lighter touch – one which largely relies upon reporting except for certain sensitive areas. Sensitive areas will remain subject to scrutiny but for the vast majority of FIEs their establishment and dealing with corporate compliance for on-going operations will become much, much simpler. 

The key changes proposed in the consultation draft FIL can be summarized as follows:

  • More Level Playing Field - Under the new framework, foreign investors will (for the most part) be subject to the same rules and procedures as domestic investors except if they fall within a “negative list” (listing prohibited or restricted sectors) or with a large total investment which exceeds review thresholds. The Draft FIL is another milestone in the on-going trend of China moving towards a level playing field for FIEs – another example is the unification of the tax system in 2008. In most instances the different rules do not really protect Chinese companies or specific national interest, but are just anachronisms that may have been relevant 30 years ago resulting in only unnecessary delays and complications today. The Draft FIL will make establishing and operating a FIE a lot simpler and cheaper.
  • Information Report to Replace Pre-Approval - Foreign investment projects not falling within the negative list will only be subject to a reporting requirement. Reports will need to include key details such as total investment amount, relevant industry, geographical scope, shareholding, organisation type and key corporate governance. In an important break from the current practice there will be no requirement to submit specific contents within the agreements between shareholders for scrutiny. This is a bold move towards greater contractual freedom between the parties as the joint venture contract would no longer require approval by the government. In practice this should also mean that minority Chinese shareholders will not automatically enjoy veto powers over key decisions which would often lead to gridlock in joint ventures.
  • New Review Process for Sensitive Projects – Projects falling within the negative list will still need to proceed with a foreign investment review procedure that considers the project’s impacts from a national security, energy resource, technological innovation, environmental, employment and public interest perspective. In many ways this also mirrors the broader arc of China’s legislative developments in recent years – relax restrictions and ease approvals for most projects but scrutinize sensitive ones more closely. The concept of negative list is borrowed from other countries such as Australia and Canada but the implementation of this concept in China will no doubt have its own wrinkles.
  • Integrated National Security Review - The national security review was a latecomer to China’s foreign investment regulatory regime in 2011[1]. Its role was not always clearly defined and despite its obvious importance it languished as a departmental regulation. The Draft FIL seeks to integrate the national security review framework and thereby elevates it from being a policy to official law. This will reinforce the critical importance that the Chinese authorities will continue to pay to national security review.
  • No Approval for Basic Corporate Dealings – The whole current Chinese foreign investment apparatus is approval based. Accordingly approval is not required just for the establishment, but also for every subsequent change in the company such as share transfers, pledges, capital increases, dissolution etc. Although this is good for lawyers, it is a source of expense, delay and, more importantly, uncertainty, for investors. The new system will no longer require prior approvals for investments, but rather these can simply be reported within 30 days.
  • New “De Facto Controller” Concept – The one area in which the Draft FIL appears to tighten matters for foreign investors is the introduction of the concept of actual (or “de facto”) control. Under the Draft FIL the determinant as to whether an investor is domestic or foreign will depend upon its actual control rather than where it is incorporated or domiciled. This new approach appears to be squarely aimed at Variable Interest Entities (“VIEs”). VIEs are domestic incorporated entities controlled by a foreign entity or person by way of contractual arrangements. 

VIEs have to date been used by both foreign investors who wish to circumvent restrictions on operating in China (e.g. sectors which are restricted to foreign investments such as in telecoms) and by Chinese investors who wished to list a China centric company offshore and were therefore forced to use an offshore vehicle for the listing (the so called “small red chips”). Many of the most well-known offshore IPOs by Chinese companies involve VIE models including such luminaries such as Alibaba, Sina, Agria etc. 

The Draft FIL clearly seeks to enforce the restrictions upon the foreign companies seeking to circumvent rules. The de facto controller concept will amount to an official sanction for VIE arrangements under which de facto control is ultimately retained by a Chinese party (such as the original Chinese founder(s) in an offshore listed company). But the Draft FIL is cautious as to how to deal with existing VIEs as this could have a significant impact upon the market.  Instead of providing a final answer, MOFCOM has mentioned three different approaches as to how legacy VIE structures may be handled.  However, while the suggested approaches have indicated possible solutions for companies ultimately controlled by Chinese investors, none were clear whether grandfathering will be granted to existing VIEs so as to enable those companies to carry on their business. This is the most worrisome for foreign investors who are relying upon a VIE model or other “legal grey area” structures to overcome a specific legal restriction. 

Possible improvements

Although the Draft FIL will generally have a very positive effect on both foreign investment and also FIEs there are areas where the draft could be improved:

  • Unclear review criteria – Despite the move to international standards (i.e. negative list and registration) old habits die hard. As is common in Chinese law the standards to be applied remain very vague and therefore the authorities will continue to retain broad discretions. Indeed, although the larger trend is towards transparency in China the rules for the national security review seem to move in the opposite direction as the Draft FIL provisions are vaguer than the existing rules. In the current rules at least the sensitive industries are listed.
  • New Reporting Requirements to MOFCOM - All FIEs will be required to submit annual reports to MOFCOM, or quarterly reports in the case of an FIE with significant assets, large revenues or multiple subsidiaries. The reporting requirements are extremely broad and may be burdensome in practice. In some ways the reporting requirements outstrip those required under the current system.  They are also much more invasive compared to countries which have served as inspiration for the system (such as Canada and Australia). There are concerns the reporting requirements will add to the compliance cost for foreign invested enterprises. Although the details of the reports remain unclear there may be an overlap with information currently provided on an annual basis to the Administration of Industry and Commerce.

Quo Vadis VIE?

On its face, the de facto controller amounts to an official sanction for VIE arrangements under which the de facto control is ultimately retained by a Chinese party (such as the original Chinese founder(s)). However, this change could potentially impact foreign investments that rely upon VIE or other “legal grey area” structures. Article 149 (as drafted) provides that foreign investors may be subject to administrative or criminal penalties if they are found to have invested in prohibited or restricted sectors without approval thorough the use of beneficial or contractual control mechanisms (i.e. VIEs).

However, the FIL is silent as to the treatment of pre-existing VIE structures. MOFCOM has provided some preliminary comments on how legacy VIE structures could be handled, while a more definite guideline is required to meaningfully assess these proposals. This will be a critically important issue for foreign investors already using such structures. Given that the VIE model has been adopted across a number of sectors we anticipate that MOFCOM will approach this issue with caution and the risk of all pre-existing VIE arrangements being declared illegal and unwound is, in our view, relatively low.

Historically, very few PRC foreign investment laws have made provisions that address the utilization of contractual agreements to effectively take control of another company.  As such, VIE’s were always in a grey area of PRC law. However, as the Draft FIL introduced for the first time the concept of “actual control” to determine whether a company is considered as a foreign invested or domestic company, the legal validity and the associated risks of VIE structures will need to be reassessed.  Furthermore, VIEs have now been recognized as a type of general investment structure for the purposes of the Draft FIL, so that VIE structures will be subject to the same restrictions as other types of corporate structures if the sector selected for business operations is listed as restricted in the Negative In this regard, it is important to note that at the same time certain restricted sectors such as value added telecommunications and education/training see some steps towards liberalization and this trend is likely to continue.

In short, the new proposed Draft FIL will likely have an effect upon VIE structures but it is too early to definitively state what the effect will be. Clarity will only exist once the legislation has been finalized and comes into force and then also once there is experience as to how the authorities interpret and implement the FIL. At the same time we expect that liberalization in many of the sectors that use VIE models will continue so it will not be just the FIL that will ultimately impact VIE structures but also whether a particular sector is included in the Negative List. The experience with the Shanghai FTZ has been that the Negative List will likely be amended several times in quick succession so it is far too early to tell now how the list will look when the Draft FIL finally comes into effect. 

Trend is apparent, timing is not

It should be stressed that the Draft FIL is still a draft and there is a long way to go before it becomes law. Under PRC law[2] there are generally five phases to the legislative process. Basically the phases are 1) Development of the draft legislation; 2) Submission and procedural review by National People’s Congress of the PRC (NPC) or the NPC Standing Committee; 3) Review by NPC delegates and NPC Legislative Committee; 4) Voting on bill; and 5) Enactment.

The length of the journey for the Draft FIL becomes even more apparent when one realizes it is currently half way through phase 1 – the development phase. At present the Draft FIL has been announced as a “Exposure Draft for Discussion” (征求意见稿) which means the first draft has been prepared by MOFCOM. Currently the MOFCOM is collecting comments and suggestions from society as a whole on the draft. Given the level of the FIL MOFCOM will need to submit the draft to the State Council which will review and revise the draft before submitting to NPC.  

In addition a complexity is that China is also negotiating bilateral investment treaties which may also impact the final text of the draft as well as the timing of its enactment.


The changes that are afoot indicate in a very real way how China has become an integral part of the global economy and is adopting international practices.

It is clear that if and when the Draft FIL comes into effect then there will be issues to be considered and actions to be undertaken. Any law that seeks to overthrow 30 years of practice will inevitably result in a complex transition and will undoubtedly lead to complexities in overlapping regulatory restrictions such as foreign exchange controls and operational licenses. Also depending on the final wording companies that are using the VIE model will need to consider how best to restructure or deal with the new environment. 

However, it would be wrong to concentrate on these issues. The transition will be over in a relatively short time and any issues will likely to be resolved quickly. China is still a country that very much welcomes foreign investment (at least in most sectors).

The Draft FIL does give cause for concern on the part of foreign investors relying on VIE models. However, it is likely too early to form any conclusion now. The trends of market liberalization and greater contractual freedom may large negate problems in this regard. In any event to consider the Draft FIL exclusively from a VIE model perspective would be wrong. The provisions in respect of VIE models will affect only a small percentage of foreign investors and ones focused on specific sectors. The bigger picture is that the Draft FIL is an indicator the Chinese government’s resolve to promote a market economy, cut red-tape and reduce administrative interference. 

Since its opening up China has been a magnet for foreign investment and foreign investment has played an important role for the country. In our opinion the new law will, for the vast of foreign investors, level the playing field and reduce the cost of doing business in China. However, it should be noted that as China develops the foreign investment (and indeed corporate) environment has become increasingly sophisticated. It has strengthened its supervision over how companies, both domestic and foreign invested, operate. This includes the recent attention given to anti-trust, compliance and unfair market practices. Foreign investors will need to re-think their operations and need additional awareness as to how to deal with the developing regulatory regime and greater operational supervision. 

*Jennifer Yao is a senior associate in King & Wood Mallesons’ Corporate Group, Beijing Office.

[1]Quoted King and Wood China Bulletin FEB 2011 VOL 46 - 
“On February 3, 2011, the State Council released the Notice on Establishing National Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ("Notice"). According to the Notice, China will implement a national security review process in relation to foreign funded mergers and acquisitions ("M&A") of domestic enterprises 30 days after the issuance of the Notice.”

[2]The Law on Legislation of the People's Republic of China and related laws and regulations

Key contacts

A Guide to Doing Business in China

We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

Doing Business in China
Share on LinkedIn Share on Facebook Share on Twitter
    You might also be interested in

    CFIUS has cleared a greenfield wind farm project in Texas, to be built by GH America Energy, a subsidiary of Shanghai-listed Guanghui Energy Co., Ltd. The project is in Val Verde County, along the...

    29 June 2020

    On 30 April, 2020, the China Securities Regulatory Commission (“CSRC”) and the National Development and Reform Commission (“NDRC”) jointly released the Circular on Work Related to Advancing the Pilot...

    24 June 2020

    On May 21, 2020, the Department of the Treasury published a proposed rule (the “Proposed Rule”) which would modify certain provisions in the regulations of the Committee on Foreign Investment in the...

    17 June 2020

    CFIUS has almost cut off international funding for the US semiconductor industry. Much of that funding—minority investments and acquisitions—came from China, which has a stated national policy of...

    17 June 2020

    This site uses cookies to enhance your experience and to help us improve the site. Please see our Privacy Policy for further information. If you continue without changing your settings, we will assume that you are happy to receive these cookies. You can change your cookie settings at any time.

    For more information on which cookies we use then please refer to our Cookie Policy.