China Law Insight : China Law Insight: China Commercial and Intellectual Property Lawyers and Attorneys, Full Service Law Firm: King & Wood

对于国内企业而言，尤其是固定资产规模较小限制类（例如网络和电信企业）外商投资企业，VIE结构被广泛用于海外上市和海外融资。一些有大量固定资产的公司也开始采用VIE结构实现海外上市。与此同时，一些海外壳公司也开始使用VIE结构以规避《关于外国投资者并购境内企业的规定》（2009年修订） 所要求的审批手续。

从政府监管的角度来看，尽管在中国没有明令禁止VIE结构，但也没有明确支持该结构。因此，VIE结构一直以来都是中国法律监管的“灰色”地带。尽管VIE结构使得境内外投资者避开了中国政府的监管，但这也同时意味着VIE结构没有得到中国政府的支持，因而VIE结构具有一些天生的弊端和潜在的法律及监管风险。

一、 近期阿里巴巴案件

如上所述，尽管广泛被应用，但VIE结构有一些天生的弊端和潜在风险，包括：（a） 根据VIE的安排，最终受益人获得的保护远不如通过直接持有运营公司的股份而获得的保护；（b） 运营公司的法律上登记的股东和实际受益人可能产生潜在的利益冲突；且（c） 如果产生争议，在执行控股公司和运营公司之间签订的协议安排时，存在不确定性。

最近发生的阿里巴巴事件（阿里巴巴2007年在香港联交所成功上市，是一家广受欢迎的网上商城）就是一个凸现VIE结构潜在风险的好例子。阿里巴巴事件预示着未来政府介入VIE结构的可能性。

阿里巴巴的结构是一个典型的VIE安排：浙江阿里巴巴乃是一个马云控制的私人公司，其实际上担任运营公司的角色，并由阿里巴巴集团通过VIE安排所控制。该安排一直相安无事，直到马云未经阿里巴巴集团控股股东（即雅虎和软银赛富）同意，便单方面决定完成支付宝70%的股权从阿里巴巴集团向浙江阿里巴巴的转让。马云的理由是如果支付宝由外国投资者持有，则其无法从中国人民银行获得必要的运营许可。

支付宝事件引起了社会对VIE结构的广泛讨论。而随之而来的广泛报道则是中国证监会向国务院提交一个内部报告（“报告”），该报告要求中国政府打压VIE这个被广泛使用但又饱受争议的结构。这使得投资者更加担心VIE结构的前景，并对今后使用VIE结构的可行性表示质疑。

二、 报告对VIE结构未来的影响

如上文所述，一直以来对VIE结构的合法性就存在极大的争议，主要因为VIE结构 （a）绕开了对外商投资的产业限制，使外国投资者可以投资于国家限制或禁止外商投资的领域；（b）其规避了商务部根据《关于外国投资者并购境内企业的规定》所要求审批的流程，尤其是针对境外壳公司进行返程投资（即中国公民通过境外的壳公司收购其境内的资产）的审批程序；及（c）在某些情况下可能构成转移定价并有逃税嫌疑。

该泄漏的报告对VIE结构的合法性进行了论述，同时分析了中国互联网公司通过VIE结构进行海外上市的现状。更加重要的是，其建议未来通过VIE结构进行海外上市必须首先通过商务部和中国证监会的同意。由于没有得到官方确认，更没有进一步的规定，该篇泄漏的报告给国内外投资者带来了极大恐慌。
尽管有上述报告，但是根据上海证券报最近的报道，上述报告乃是中国证监会内部研究部门的一篇报告，仅为内部学习交流之用。因此，这不是一个提交国务院的正式报告，因此其实际的可执行性目前尚不明朗。

尽管如此，投资者应当注意：由于通过VIE结构规避中国政府监管进行海外上市已经逐渐从传统的轻质资产领域向重资产领域演变（例如铁路和矿产领域），因此中国政府监管VIE结构的动机变得愈发强烈。尽管我们预计短期内政府不会对VIE结构采取严厉措施，但长远来说，这是一个中国政府极有可能会处理的问题。

三、 国家安全审查对VIE结构的潜在影响

尽管目前没有任何法律、法规直接监管VIE结构，但如果目的是规避中国政府的安全审查，则最近中国政府建立的国家安全审查制度可能会阻止该类外资并购境内企业的交易。如同许多其他国家的类似制度一样，如果外资并购涉及一些可能影响中国国家安全的关键领域（如军事、核心技术和农产品等），则国家安全审查制度已赋予政府相应权力，来审查及批准此类拟进行的外资并购。尽管如此，由于新实行的国家安全审查法律规定比较宽泛、且在实践中自由裁量的空间很大，外国投资通过VIE结构投资关键产业是否会被认为是一项并购交易因而被要求进行国家安全审查尚不明朗。
国家安全审查制度可能成为商务部否决使用VIE结构的一个途径。然而，由于目前实践中尚没有先例，目前尚不确定中国政府是否会将国家安全审查制度作为一种手段，对通过VIE结构进行的外商投资行为进行监管。

（本文原文为英文，中文为译文。）

1  Overview

The VIE structure is also commonly referred to as the Sina-model structure, since it was first used by Sina in 2000.  In China, the foreign direct investment market is not totally open to foreign investors.  According to the Provisions on Guiding the Orientation of Foreign Investment, promulgated in 2002, and the Foreign Investment Industrial Guidance Catalogue revised in 2007, we understand that the industries are classified into four categories, namely, the encouraged, permitted, restricted and prohibited.  With respect to the encouraged and permitted industries, there are few restrictions on foreign investment, which means that foreign investors may usually make investments freely in those industries.  As to those restricted industries, higher conditions or qualifications or stricter requirements are provided for foreign investors.  Foreign investors are not permitted to invest in prohibited industries at all.  Those companies which adopted the VIE structure, in a sense, usually face restrictions on foreign investors, and for the purpose of attracting foreign venture capital or private equity financing in the early stages and completing offshore listings, the VIE structure was finally created by certain imaginative individuals in an effort to circumvent certain legal restrictions which they encountered in China.

In recent years, more than one hundred Chinese companies have adopted the VIE structure for their offshore listings, including internet companies such as Alibaba, Tencent, Baidu, Sina, Tudou, etc.; private education companies such as New Oriental, Global Education & Technology Group and AMBOW Education, etc.; media companies such as Focus Media, Vision China Meida and Bona, etc.; retail companies and companies in other industries.  The typical VIE structure is set up as illustrated in the following diagram:

As indicated in the diagram above, foreign investors and PRC individuals establish SPV1 in Cayman; then SPV1 sets up a wholly-owned SPV2 in Hong Kong; and then SPV2 establishes the wholly foreign-owned enterprise ("WFOE") in the PRC.  The domestic company usually is the one which owns licenses or approvals for the business.  However, due to restrictions on foreign investment, the WFOE cannot obtain licenses or approvals from the PRC authorities to operate in the desired industry.  Through a set of contractual arrangements among the WFOE, PRC individuals (usually PRC individuals are the companies' founders) and the domestic company, the WFOE may be able to actually control the domestic company as if it directly owned the equity interests in such domestic company.  Thus SPV1 may consolidate the financials of the domestic company into the group's overall financial statements, which is permitted and accepted by the US General Accepted Accounting Principles.

In practice, the contractual arrangements include:

(i) the Consulting and Service Agreement entered into by and between the WFOE and the domestic company, which provides that the WFOE shall provide certain services (for example, the consulting or strategic services and technical services) to the domestic company for a fee, typically determined by the WFOE with the intended result of shifting the domestic company’s profits to the WFOE;

(ii) the Asset License Agreement entered into by and between the WFOE and the domestic company, under which the WFOE licenses certain assets including intellectual properties to the WFOE for royalty fees;

(iii) the Voting Rights Agreement or Proxy entered into by and among the WFOE, PRC individuals and the domestic company, in which the domestic company’s shareholder--PRC individuals authorize the WFOE to exercise their shareholders rights in the domestic company, including voting rights, inspection/information rights, signing rights and election rights, etc.;

(iv) the Call Option Agreement entered into by and among the WFOE, PRC individuals and the domestic company, in which PRC individuals grant the WFOE an option to purchase all or a portion of their equity interests in the domestic company at a lowest possible price permitted by PRC law;

(v) the Equity Pledge Agreement entered into by and among the WFOE, PRC individuals and the domestic company, through which the PRC individuals pledge their equity interests in the domestic company to the WFOE as a guarantee of the performance of their and the domestic company’s obligations under other agreements among the three (3) parties in the VIE structure; and

(vi) the Loan Agreement entered into by and between the WFOE and PRC individuals, in which the WFOE extends a loan to PRC individuals to use for capitalization of the domestic company.

The cash flow goes like this:  SPV1 will fund the SPV2.  SPV2 will make a capital contribution to the WFOE.  The WFOE will extend a loan to the PRC individuals, who will in turn establish and finance the PRC domestic company.  When the PRC domestic company makes a profit, it will distribute a dividend to the PRC individuals.  The PRC individuals will make a repayment of the loan to the WFOE.  The WFOE will use the proceeds of the loan together with other funds to be discussed below to make a dividend distribution offshore to SPV2, which will in turn make a dividend distribution to SPV1.  In addition, through the contractual arrangements between the WFOE and the PRC domestic company, the domestic company will also make certain payments to the WFOE for provision of services.  This payment will be part of the dividend to be distributed by the WFOE offshore, thus completing the chain of cash flow.

At the beginning, the VIE structure was used primarily for asset-light companies, such as internet companies, advertising companies, software companies, education companies and media companies, etc.  However, after several years’ development, the asset-heavy companies also began to choose VIE structures for their financing or offshore listing and the typical example was China Qinfa Group Limited.  Recently, the VIE structure has been increasingly used by asset-heavy companies.

2  Risks

During the last decade, with various investors' efforts, the VIE structure has become more and more familiar to foreign investors, Chinese companies and the PRC authorities, and has been widely used in foreign investments in China, especially in the restricted or prohibited industries to foreign investors.  However, for foreign investors, the potential risks existing in the VIE structure and uncertainties in respect of government policies are just like the Sword of Damocles over their heads.  We will analyze the risks associated with the VIE structure in the following section.

2.1 Risks associated with the VIE structure

From series of contractual arrangements elaborately designed by investors, companies and other market participants, it is not hard to find that the VIE structure is crafted to remove any risk of the WFOE losing control of the domestic company or its assets.  Due to the reluctance of the parties from disclosing the entire structure of the transaction, the enforcement of such contractual arrangements is likely to be difficult in China.  Moreover, even if the contractual arrangements are finally enforced under PRC law, the damages to the company will be significant for the investors.  After all, to some extent, the contractual arrangements cannot be compared with the direct ownership of the domestic company through equity investment.

For instance, if all parties to the contractual arrangements perform their obligations, everything is fine.  However, if, for example, the PRC individuals or the domestic company decide not to perform their obligations under the contracts, the WFOE may have a difficult time to maintain control over the PRC domestic company.  Consequently, we have known some limited but significant cases in which the offshore holding companies lost control over the domestic companies.  The result is typically difficult, expensive and time-consuming dispute resolution process, which may lead to some kind of settlement or, alternatively, the foreign investor giving up on the PRC domestic company and their presence in China.

Most of time, we only notice there have been more than one hundred Chinese companies which successfully achieved listing overseas.  On the other hand, we tend to pay little attention to such failed cases in which the domestic foreign investors even lost control over the domestic companies.  However, in any case, the potential risk still exists for each market participant and is worthy of consideration by foreign investors at the stage of designing the transaction structure.

In the listing process of Sina, when one Sina's founder was removed from Sina, the VIE structure was affected by such change of senior officers or shareholders of domestic companies.  Although the adverse effect was successfully eliminated and the VIE structure was retained at last, the instability from the structure is still a high profile case in the VIE's history.  Another case is Agria Corporation, a Chinese seed producer which completed its IPO on NASDAQ in 2007, and which also faced the risk of losing control of the domestic company and such risk was eventually settled through compensation in equity and cash to the founder of domestic company (he was also the former director and the legal representative of the domestic company) who claimed the ownership of the offshore parent company.

Sina and Agria Corporation both faced the risk of losing VIE structure, but fortunately, after hard negotiation, such risk was successfully removed and the VIE structure was retained eventually.  Certainly, there are also not so exciting examples for foreign investors.  One is GigaMedia and the other is Alipay.

GigaMedia is a listed company on NASDAQ, which owns online games business in China through the VIE structure.  In 2010, GigaMedia announced it was involved in the dispute with its former founder of the domestic company, who was removed from the domestic company but refused to return the company seal, financial chops and other documentation to GigaMedia.  As a result, such former founder in fact still controls the domestic company.  Even though there are a set of contractual arrangements, GigaMedia has no choice except to bring a series of legal actions against such former founder inside and outside of China.  Furthermore, even though GigaMedia may regain the ownership and control of the domestic company, it is undeniable that such event will bring adverse effect on its business in China and its actual control of such domestic company.  Additionally, GigaMedia has already had to announce that it would deconsolidate the financials of domestic company subject to the resolution of such dispute.

Alipay is another classic case which may be repeated by foreign investors and other market participants over and over again.  The VIE structure was set up between Alibaba Group and Alipay.  Alibaba Group's shareholders were Yahoo, Softbank, Jack Ma and other PRC individuals.  In 2011, Jack Ma, the founder of Alipay successfully severed such VIE structure between Alibaba Group and Alipay, and committed to make certain compensation to Yahoo and Softbank in the future.  From the announcement by Jack Ma, the reason of unwinding the VIE structure was to obtain the Payment Business License from the PRC authorities, because only those domestic companies which had the qualifications could apply for the Payment Business License and the VIE structure would not be accepted by the PRC authorities.  Alipay eventually set off a big bomb in the Chinese private equity market.  As a result, many investors began to re-examine the VIE structure.

From the above cases, it is not difficult to find that the VIE structure is not as stable as some have imagined, to say the least.  The founder, senior management or shareholder of the domestic company play a very important role in the VIE structure.  Once there are changes to such positions involving interests, potential risks of the VIE structure will appear.  The VIE structure helped over one hundred Chinese companies complete the offshore listings, but we should never forget such potential risks when we discuss the successful cases.

2.2 Risks from governmental policies

Why did Chinese companies, foreign investors and other market participants create the VIE structure?  They were not unaware of the potential risks of the VIE structure, but they still adopted it, because they had no other choices when faced with the restrictions on foreign investment in China.  In fact, most companies using the VIE structure have attracted foreign financings, but at the same time most of them face restrictions on foreign investment.  After obtaining supports from foreign funds or other foreign investors, Chinese internet companies got rapid and great development and some internet giants such as Baidu, Alibaba and Tencent, etc., have grown up in the last decade.  Of course, in those cases, Chinese companies avoided the restrictions on foreign investment and all relevant the PRC authorities' approvals by using the VIE structures.

Sina might have chosen to use the VIE structure in 2000, to some extent, because it obtained the tacit consent from the PRC authorities.  Over past years, the PRC authorities never formally confirmed the validity of the VIE structure under PRC law.  As a general rule, the PRC authorities typically do not like the idea of foreign investors using indirect ways to get around legal restrictions on foreign investment in the first place; however, in order to attract foreign investment in technology focused industries such as telecommunications and internet, the PRC authorities have tended to acquiesce the usage of the VIE structure in China.  That is beginning to change, because while the PRC authorities still welcome foreign investment, they have begun to be more concerned about "hot" money flowing into China through less than above-board means.  As a result, the scale has tipped from welcoming foreign investment to higher scrutiny of the legality of the transaction structure.  With prevalence of the VIE structures, some subsequent regulations or cases imply or reveal the PRC authorities' attitude which is not so positive at least at present.

(a) Circular  

The Circular on Strengthening the Administration of Foreign Investment in Value-added Telecommunications Services ("Circular") promulgated by the Ministry of Industry and Information Technology ("MIIT") on 13 July 2006 was the first attempt to explicitly circumscribe the use of the VIE structure.  In the Circular, it is provided that a telecommunications enterprise within the territory of China may not lease, shift or sell any license for telecommunications business in any form, or provide resources, places and facilities or any other conditions for any foreign investor to engage in any illegal telecommunications operation by any means within the territory of China.  Meanwhile, certain key assets including trademarks, domain names and servers shall be held by the value-added telecommunications service provider or its shareholder which holds the value-added telecommunication service license.  This Circular states that the PRC authorities do not welcome the VIE structure in the value-added telecommunications service area.  This Circular also requires that the telecommunications enterprise which plans to list oversea shall first get the approval from MIIT.

(b) Online Games Notice

The Notice on Further Strengthening of the Administration of Pre-examination and Approval of Online Games and the Examination and Approval of Imported Online Games  ("Online Games Notice") promulgated on 28 September 2009, provides that foreign investors are not permitted to invest in online games operating businesses in China via the WFOE, equity joint venture, or contractual joint venture, and it also expressly prohibits foreign investors from gaining control over or participating in domestic online games operators by indirect means, such as setting up other joint ventures, signing relevant agreements or providing technical supports.  We are not aware of whether any listed companies utilizing the VIE structure were penalized or required to take apart the VIE structure.

From the regulatory perspective, the Circular and Online Games Notice are both only regulations other than laws; however, such regulations at least send a signal on use of the VIE structure.  Meanwhile, most experts on VIE still believe that the PRC authorities are unlikely to prohibit all VIE structures.

(c) National Security Review

On 3 February 2011, the State Council released the Notice on Establishing National Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ("Notice").  To specify the implementation procedures of the national security review, later, on 4 March 2011, the Ministry of Commerce ("MOFCOM") promulgated the Interim Rules on Issues Related to the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Interim Rules"), which is replaced by the Rules on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Rules") on 1 September 2011.

Article 9 of the Rules re-attracts concerns from the public, which provides that with respect to merger and acquisition ("M&A") of the domestic enterprise by foreign investors, whether the M&A transaction falls within the scope of national security review shall be judged from the substantive contents and actual influences of the transaction; and foreign investors shall not avoid national security review through any means, including without limitation commissioned shareholdings, trusts, multi-level investments, leases, loans, contractual control, overseas transactions, etc.

The "contractual control" mentioned in the Rules obviously refers to the VIE structure.  However, after reviewing the Notice and Rules, we may find that not all M&A deals will be subject to a national security review.  The national security review process will apply only if the target domestic enterprise is involved in a business that concerns either national defense security issues ("National Defense Security Businesses") or national economic security issues ("National Economic Security Businesses").  National Defense Security Businesses include military industry enterprises and supporting enterprises, enterprises adjacent to major and sensitive military facilities, and other entities relevant to the national security of China.  National Economic Security Businesses include enterprises involving major agricultural products, major natural resources and energy industries, important infrastructure projects, transportation services, key technologies, as well as major equipments that are related to national security.  It is worth noting that in relation to M&A deals involving National Economic Security Businesses, a national security review process may only be triggered if the foreign investor intends to acquire actual control of the target domestic company.

In addition, the M&A in the Notice refers to the following circumstances:

(i) Foreign investors purchase equity interests of domestic non-foreign invested enterprises or subscribe for capital increase of domestic non-foreign invested enterprises, which convert such domestic enterprises into foreign invested enterprises.

(ii) Foreign investors purchase equity interests of domestic foreign invested enterprises owned by Chinese shareholders, or subscribe for capital increase of domestic foreign invested enterprises.

(iii) Foreign investors establish foreign invested enterprises and purchase assets of domestic enterprises via agreements by such foreign invested enterprises and then operate these assets, or purchase equity interests of domestic enterprises by such foreign invested enterprises; and

(iv) Foreign investors directly purchase assets of domestic enterprises and establish foreign invested enterprises through such assets to operate such assets.

Combining the Notice and Rules, we may conclude that the VIE structure has attracted increased attention from the PRC authorities, and such regulations only indicate that the PRC authorities have the intention to restrict the use of the VIE structure in certain industries.  From existing PRC laws and regulations, it is hard to get a conclusion that the VIE structure will be prohibited in all areas.

It is also worth considering whether the existing VIE structures before promulgation of the Rules will be unwound or will face penalty.  Since there are no more supporting materials from practical cases, at least until now, we are not aware of any companies with existing VIE structure facing risks of penalty or risk of unwinding the VIE structure.  However, based on our experience, it is likely that previously established VIE structures may be left untouched.  In addition, investment into such pre-existing VIE structures on an offshore level might not attract the attention or objection from the PRC authorities.  However, foreign investors should examine all facts and review all relevant laws and regulations before making a decision to create a new VIE structure in certain industries on a case by case basis.

(d) Practice

The promulgation of the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors ("M&A Rules") on 8 August 2006 by six (6) PRC departments, provides that the domestic companies, enterprises or natural persons shall, when they merger and acquire related domestic companies through companies legally established or controlled by them in foreign countries, report to MOFCOM for approval and the persons concerned may not evade the above requirements by re-investment of the foreign-invested enterprises or by other means.  The M&A Rules leaves a road for related M&A, i.e. to obtain the approval from MOFCOM.  However, during the five (5) years after the promulgation of the M&A Rules, there is no case where the approval was successfully obtained.

It is clear that since the issuance of the M&A Rules, more and more Chinese companies have adopted the VIE structure.  In the early stage, the VIE structure was almost only used on the asset-light companies.  However, after 2006, those asset-heavy companies also chose to utilize the VIE structure.  It is believed that one of the reasons for the increasing use of the VIE structure is that the VIE structure may avoid obtaining the approval from MOFCOM.  In fact, it is unimaginable and unreasonable that such asset-heavy companies may move enormous assets out of China only by several agreements without any governmental approval or other legal procedures.  The PRC authorities may also be on the alert for the abuse of VIE structure in asset-heavy industries.  There are some cases which adopted the VIE structure in the asset-heavy industries and successfully listed overseas, but unfortunately we also understand there are cases which have been rejected at IPO just for using the VIE structure in the asset-heavy industries.

In early 2011, Buddha Steel withdrew its IPO in USA, citing that the company was advised by local governmental authorities in Hebei Province that its VIE structure contravened the current Chinese management policies related to foreign-invested enterprises.  On the one hand, this case might simply reflect the local government's attitude towards specific companies or industries, not towards the VIE structure itself.  On the other hand, it reveals that different local governments may hold different views regarding the VIE structure.

Above all, no matter from the legislation perspective or on a practical level, it is clear that the VIE structure faces the risks of uncertainty on policies from the PRC authorities.

3  Conclusion

In summary, the VIE structure has brought the prosperity to the Chinese internet market, and the VIE structure also had potential risks due to governmental polices in the past ten years or so since its appearance.

With respect to the risks from the structure, from the above analysis we may find that the certain persons in the domestic companies usually play a critical role in the VIE structure, and we all understand it is very important for the WFOE or offshore companies to avoid the risks from such persons.  To better maintain the stability of the VIE structure, the following options may be adopted:

(i) Diversify the shareholding of the domestic company.  If no shareholder alone or in conjunction with other shareholders, over whom he/she may bring influences, may control the domestic company, at least, it may help to reduce the risk of losing control of the domestic company.  The perfect arrangement would be that each shareholder alone or in conjunction with other related shareholders holds less than 33% equity interests of the domestic company.

(ii) Carefully appoint the directors and the legal representative of the domestic company.  In the GigaMedia case, the former legal representative refused to return the chops and documentations of the domestic company.  In order to avoid such similar events from occurring again, when appointing directors and the legal representative, the WFOE or offshore companies should carefully consider the proper persons who will represent the interests of the WFOE or offshore companies.

(iii) Balance the interests between the persons controlling the domestic companies and those representing the offshore companies.  Once the persons who control the domestic companies may get reasonable or greater returns from the offshore companies, the risk on severing the VIE structure by them will be reduced accordingly.

In respect of the risks from governmental polices, before establishing the VIE structure, the companies should ensure that the VIE structures are in compliance with PRC law and may be enforceable in the future.  Considering the limited cases on national security review or other polices in practice, we would suggest that the companies should communicate with the PRC authorities first, obtain professional advice on a case by case basis, and then make a decision whether to utilize the VIE structure or how to use it properly.

试点企业是指经市备案办报主管市领导认定的试点股权投资管理机构和试点股权投资企业。市发展改革委召集市备案办成员单位评审符合试点要求的，由市发展改革委上报主管市领导同意后，市发展改革委通知申请企业可以参与试点。

《办法》规定，试点企业应当采用公司制、有限合伙制组织形式设立;股权投资管理机构实收(实缴)资本不少于1000万元人民币或等值外币;申请试点股权投资企业中的境外出资人，在其申请前的上一会计年度，具备自有资产规模不低于5亿美元或者管理资产规模不低于10亿美元。《办法》还要求，每个境外出资人至少在试点股权投资企业中出资1000万美元以上。香港特别行政区、澳门特别行政区、台湾地区的投资者在本市投资设立股权投资企业和股权投资管理机构参与试点的，将参照本办法执行。

对于外资PE而言，国民待遇是其获取QFLP试点资格的最终诉求。关于国民待遇，津版细则中有明显优于其他三地之处：其一，在股权投资基金资金来源方面，天津QFLP允许基金全部由境外募集的外币资金构成，或由境外募集外币资金和境内募集人民币资金共同构成。上海及重庆并未对基金资金来源提出具体要求，而北京方面则要求由境内募集人民币资金和境外募集外币资金共同构成，外资认缴金额原则上不得超过基金规模的50.0%。其二，允许外商投资基金管理企业以其部分外汇资本结汇用于对募集管理的股权投资基金的出资，并批准当外商投资基金管理企业出资金额不超过所募集资金总额度的5%，该基金享受国民待遇，不受投资领域限制。而在沪版QFLP中，此条要求需追加“且无境外LP”时方可享受国民待遇。

1. Scope of Offshore RMB

The Offshore RMB mainly includes (1) RMB legally acquired by foreign investors through settlement of international trade; (2) RMB remitted outbound which acquired through  profit distribution, equity transfer, reduction of registered capital, liquidation or early return of investment in mainland China and (3) RMB legally acquired or raised through issuing RMB bonds or stocks outbound and other legal channels.

2. The Industries the Offshore RMB Can Be Invested in

The Circular provides that Offshore RMB investment shall comply with foreign direct investment rules in China, and it also provides some exceptions for Outbound RMB investment, such as the securities or financial derivatives in mainland China. In addition, the Outbound RMB can not be invested in entrustment (inter-company) loans.

3. Investment Approval Procedure

Generally, the approval authorities are unchanged. The commerce departments at all levels are responsible for examination and approval of offshore RMB direct investment review. The provincial authorities must submit with MOFCOM for review before approving of investment under the circumstances that: (1)investment amounts to RMB300 million Yuan or above or investment  in financing guarantees; (2) investment in foreign invested investment companies ; and (3) investment in sectors that are subject to macro-economic control of the State, such as sectors as cement, steel and iron. MOFCOM will gradually simplify the procedures concerned based on the practice of cross-border RMB direct investment.

It can be inferred that Offshore RMB can be used to invest in a foreign invested investment company (e.g. a PE firm) in China.  However, in addition to the usual approval procedures for all foreign investments, it is also subject to MOFCOM approval (as described above). The prolonged approval procedure may cause more uncertainties.

1. 境外人民币的范围

境外人民币主要包括：（1）通过跨境贸易人民币结算取得的人民币；（2）汇出境外的人民币利润和转股、减资、清算、先行回收投资所得人民币；（3）在境外通过发行人民币债券、人民币股票以及其他合法渠道取得的人民币。

2. 境外人民币投资流向

《通知》规定境外人民币直接投资应符合现行外商投资管理体制，并且规定了一些禁止投资的行业，例如跨境人民币直接投资在中国境内不得直接或间接用于投资有价证券和金融衍生品，以及用于委托贷款。

3. 境外人民币投资许可

《通知》总体上没有改变现有外商直接投资的审批权限，由各级商务主管部门按照现行外商投资审批管理规定审批跨境人民币直接投资。对于（1）3亿及3亿以上投资项目以及融资担保；（2）外商投资性公司；（3）宏观调控行业等项目，省级商务主管部门需报商务部审核同意后予以批准，商务部将根据跨境人民币直接投资的实践情况逐步简化有关程序。
从上面可以看出，境外人民币可以投向外商投资的投资性公司或私募公司，但除了通常的外商投资审批程序，投资还要经商务部进行批准，这无疑对投资过程造成更多不确定性。

In essence a VIE structure refers to a structure whereby an entity established in China which is fully or partially foreign owned ("Controlling Company") has control over an operating company ("Operation Company") which holds the necessary license(s) to operate in a FDI restricted/prohibited sector. As such sector is restricted/prohibited by the PRC authorities, the foreign investors are not able to directly invest in such Operation Company. Accordingly, the foreign investors adopt various contractual arrangements between the Controlling Company and the Operation Company in order to obtain de facto control over the operation and management of the Operation Company. The profits of such Operation Company would also flow back to the Controlling Company and then ultimately be consolidated by the foreign investors.

For domestic companies, especially companies in the restrictive industries without much physical assets (such as internet or telecommunication), the VIE structure was widely used to enable them to obtain financing from overseas market through overseas listings. Gradually, companies from heavy industries also started to adopt the VIE structure to list overseas and the overseas shell company started adopting such VIE structure to circumvent the approval requirement stipulated by relevant PRC M&A Rules[1].

From the government's perspective, although there is no clear prohibition against the VIE structure in China there has also been clearly no express endorsement of the VIE structure either. Accordingly, the VIE structure has always been a grey area in the Chinese legal system.  Although the VIE structure allows both the domestic and foreign investors to circumvent government reviews and regulation, this also means that the VIE structure does not have the backing of the authority and therefore the VIE structure possesses inherent defects and potential legal and regulatory risks.

Recent Alibaba case

Despite its popularity there are inherent defects and risks for the VIE structure involving: (a) the level of protection enjoyed by the beneficial owners from VIE arrangement is far lower than a direct equity holding in the Operating Company; (b) the potential conflict of interests between the legal shareholders of the Operating Company and the beneficial owners; and (c) the level of uncertainty in the enforceability of the VIE contractual arrangements between the Controlling Company and the Operating Company in the event of a dispute.

The recent case of Alibaba, a wildly popular shopping website which had a successful IPO on the Hong Kong stock exchange in 2007, is a good example illustrating the potential risks of VIE structure and that illustrates reason for possible government intervention in the future.
 

Alibaba's structure is a typical VIE arrangement: Zhejiang Alibaba, a private company held by Ma Yun and acting as an operating company, was in fact controlled by Alibaba Group Holding through a VIE arrangement. No problem arose until Ma Yun decided to complete a 70% equity transfer of Alipay from Alibaba Group Holding to Zhejiang Alibaba allegedly without majority shareholders' approval on the part of the Alibaba Group (i.e. Yahoo and Softbank). The argument from Ma Yun was that Alipay would be unable to acquire the necessary operational license from the People' Bank of China if it was held by foreign investors.

The Alibaba matter shone a spotlight on VIE arrangements and it has been widely reported that CSRC[2], China's securities regulator, submitted an internal report to the State Council asking the government to clamp down on this controversial yet popular corporate structure. This has resulted in even greater concerns on the part of investors and cast doubts as to the feasibility of the VIE structure going forward.

The Implication of the Report on the future of VIE structure

There have always been great controversy regarding the legality of the VIE structure, mainly because (a) it circumvents the restrictions on foreign investors making it possible for them to invest in restricted/prohibited industries in PRC; (a) it circumvents approval requirements by Ministry of Commerce ("MOFCOM") in accordance with the M&A Rules, especially by offshore shell company making round trip investments (i.e. where PRC owned businesses and assets are owned by an offshore entity owned by the PRC owners); and (c) it may constitute price transferring and consequently result in tax evasion in some cases.

The leaked report supposedly analyses the legality of the VIE structure as well as the current status of PRC internet companies listed overseas by using VIE structure and more importantly, it recommends future overseas listings using a VIE structure should first obtain MOFCOM and CSRC approval. The leaked Report, is causing gave concerns for foreign and domestic investors alike as nothing has been officially confirmed much less what requirements will be introduced.

Notwithstanding the above, it was recently reported by the Shanghai Securities News that the Report, which was allegedly drafted by a research department of CSRC, was created solely for internal study and communication. Therefore, it is not an official report submitted to the State Council and therefore the actual implementation, if any, is unclear.

However, the investors should note that since the overseas listing of domestic companies by way of VIE structure has gradually been extended from the traditional light industries to heavy industries involving material assets (such as railways, minerals) and therefore also avoiding PRC government supervision, the motivation for the PRC government to regulate the VIE structure has become greater. Although we expect the government will not launch a severe clamp down upon the VIE structure in the short run, it is an issue very likely to be tackled by the government at some time in the future.

Potential effect from NSR system on the VIE structure

Even though currently there are no laws or regulations directly regulating the VIE structure, a newly established National Security Review ("NSR") system by the Chinese government may prevent foreign acquisitions of domestic companies if the purpose is to evade the governmental security review. This system, similar to those in many other countries, bestows upon the government the authority to review and approve a proposed foreign M&A transaction if it involves one of several key sectors (i.e. military, key technology and agricultural products) that have a bearing on China's national security. However, since these newly enacted security review regulations are broad and highly discretionary in practice, whether a foreign investment which uses a VIE structure in a key industry will be constituted as a M&A transaction and consequently be required to go through NSR procedure is unclear.

The NSR review may be a means by which MOFCOM may strike down transactions using the VIE structure. However, as currently no precedent case has occurred it is still uncertain whether the NSR system would be used by the government as a step to bring foreign investments using VIE structure under their supervision

(This article was first published on XBMA.com)

Notes:

[1] Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors, revised in 2009.
[2] China Securities Regulatory Commission.

以下是《通知》中值得关注的要点：

人民币贸易负债: 跨境贸易人民币结算项下涉及的居民对非居民的人民币负债，包括与跨境贸易人民币结算相关的远期信用证、海外代付、协议付款、预收延付及其他类型的贸易负债将不纳入现行外债管理。这将有利于构建链接境内外资本市场的人民币自由通道。

人民币外商直接投资: 《通知》强调目前人民币外商直接投资尚处于试点阶段，出于防范热钱流入的考虑，个案申请须取得中国人民银行总行的批准。《通知》明确了如何获得中国人民银行批准的详细申请流程，即外国投资者或境内外商独资企业可以通过其境内结算银行向所在地中国人民银行分支机构提交人民币外商直接投资申请和事先已经获得的商务部的批准文件或批准证书。上述申请文件将由中国人民银行分支机构上报总行进行最终审批。上述审批程序适用于新设立企业出资、并购境内企业(不含返程并购)、股权转让以及对现有企业进行增资、提供股东贷款。目前，人民币外商直接投资业务试点对国家限制类和重点调控行业的人民币外商直接投资项目暂不受理(可能涉及金融和房地产领域)。现实中，国家外汇管理局和商务部在实践操作中对中国人民银行新规的反应尚未可知，但境内银行很有可能将会积极的依照中国人民银行的要求进行操作。

真实性审查: 境内银行有义务审核客户提出的人民币结算需求是否有真实交易所支持。境内结算银行及境外参加银行通常情况下不得向无真实跨境交易背景仅以套汇为目的(如人民币无本金交割远期合约)的申请者提供人民币结算服务。另外，境内企业进口支付的人民币不得在境外(含香港)直接购汇后支付给境外出口商，且境内结算银行不得提供此种人民币结算服务。

为便于理解，我们准备了下表列明了目前跨境人民币相关业务的审批机关及相应审批权限。

联系方式

如您需要任何进一步的信息，请联系：

北京
王玲
北京市朝阳区东三环中路7号
北京财富中心写字楼A座40层
电话：+86 10 5878 5016
传真：+86 10 5878 5599
Email: wangling@kingandwood.com

上海
张宁/ 钟鑫
上海市淮海中路999号
上海环贸广场写字楼一期16－18楼
电话：+86 21 2412 6053 / 6055
传真：+86 21 2412 6250
Email: roy.zhang@kingandwood.com
            zhongxin@kingandwood.com

We highlight the key points of the Circular worth noting as follows:

• RMB Trade Indebtedness: Payment obligations owed by PRC residents to offshore counterparties under cross-border RMB trade transactions, including without limitation the issue of RMB usance L/C, offshore advance payment and deferral payment and other forms of trade indebtedness would not be deemed as foreign debts.  This will make it easier to create a free-flowing channel of RMB funds between the onshore and offshore capital markets.

• RMB Guarantee or L/C issued by onshore banks in favor of offshore entities would not fall within the regime of foreign security/guarantee.  It would relieve onshore banks from the foreign security quota concerns.  More opportunities may be explored where the offshore entities are willing to accept RMB guarantee or RMB L/C to back offshore lending.  The RMB guarantee or L/C, if structured properly (mainly using RMB guarantee/L/C as a vehicle for offshore lenders to gain a pari passu position with onshore lenders), may resolve the traditional pitfall embedded in the onshore/offshore structure where offshore lender cannot get access to onshore collateral.

• RMB FDI: The Circular emphasizes that so far the RMB FDI transactions is still at its pilot stage and should be subject to PBOC head office approval on a case-by-case basis, primarily for prevention of hot-money inflows. However, it does provide a detailed step-by-step process on how to obtain PBOC's approval. According to the process, foreign investors or WFOEs shall ask their settlement banks in China to submit the RMB FDI applications to particular PBOC offices together with pre-obtained MOFCOM approvals for the same transaction.  Complete applications will be handed over to PBOC head office for final approval. This approval requirement applies to greenfield projects, M&As of onshore enterprises (excluding round-trip investments), equity transfer and shareholder loans.  At this moment PBOC does not accept applications for transactions falling within the "restricted" category or under policy control (presumably this refers to financial and real estate sector).  Although it remains yet to be seen how in practice SAFE and MOFCOM will react to the PBOC requirement, it is likely that onshore banks will be keen to follow the PBOC requirement, thus making it a requirement for banks' client to comply with.

• Genuine Trade Review: PBOC requires onshore to verify whether there are genuine transactions behind RMB settlement request from customers.  Onshore settlement banks as well as offshore participation banks are generally not allowed to provide RMB settlement services if the applicant is pursuing arbitrage (such as RMB-NDF contracts) without any genuine RMB cross-border trade background. Moreover, onshore settlement banks are kept from providing RMB settlement services to onshore importers under the situation where the onshore importers intend to do currency conversions outside mainland China and settle the transaction with offshore exporters.

For you ease of reference, we summarize in the appendix a matrix which identifies the relevant regulatory authorities for various types of RMB cross-order capital-account transactions and regulatory authorities' discretions on specific businesses.

Contacts

For further information on the matters covered in this newsletter, please contact:

Beijing Office

Wang Ling
King & Wood
40th Floor Office Tower A, Beijing Fortune Plaza
7 Dongsanhuan Zhonglu
Chaoyang District Beijing
China
Tel: +86 10 5878 5056
Fax: +86 10 5878 5599
Email: wangling@kingandwood.com

Shanghai Office

Roy Zhang / Zhong Xin
King & Wood
16-18/F, One ICC, Shanghai ICC
999 Huai Hai Road (M), Shanghai
China
Tel: +86 21 2412 6053 / 6055
Fax: +86 21 2412 6250
Email: roy.zhang@kingandwood.com
             zhongxin@kingandwood.com

Notes:

(1) The PBOC Circular on Clarifying Relevant Issues of Cross-border RMB Transactions (《中国人民银行关于明确跨境人民币业务相关问题的通知(银发[2011]145号》).

1 Background

As early as 2003, China issued provisional rules governing acquisition of domestic companies by foreign investors, and on August 8, 2006, these provisional rules were amended into the Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors ("M&A Rule") by the Ministry of Commerce ("MOFCOM") and five other agencies. The M&A Rule, for the first time, called for notification and review of a transaction that might have an impact on China's "national economic security". Subsequent to the M&A Rule, the PRC Anti-Monopoly Law ("AML"), effective on August 1, 2008, mandates a broader "national security" review when a foreign investor participates in the concentration of business operators by merging or acquiring a domestic enterprise or by any other means where national security is involved. Following the AML, on April 6, 2010, the PRC State Council issued the Several Opinions on Further Improving the Work of Utilizing Foreign Investment, which directs the government to accelerate the establishment of a national security review mechanism on mergers and acquisitions of domestic companies by foreign investors.

2 Highlight of the Notice

The Notice sets up a ministry-level intra-agency joint meeting as the national security review committee. It also lays out the scope and content of national security review as well as the mechanism and the procedures for the review.

2.1 Scope of Review

National security review covers the following areas:

•  
• national defense security, including foreign investors' acquisition of military enterprises and military supporting enterprises, enterprises adjacent to important and sensitive military facilities and other entities relating to national defense security; and 

• other national security areas, including foreign investors' acquisition of enterprises involving important agricultural products, energy and resources, infrastructure, transport systems, key technology sectors and important equipment manufacturers which may have an impact on national security and foreign investors may acquire de facto control of such enterprises.

Under the Notice, the term "de facto control" refers to the following circumstances:

•  
• a foreign investor and its parent company and subsidiaries hold in the aggregate more than 50% of total shares of a domestic company after acquisition;

• several foreign investors hold more than 50% of total shares of a domestic company after acquisition;

• a foreign investor holds less than 50% of total shares of a domestic company after acquisition, but the voting right of the foreign investor could have significant effect on the resolutions of the shareholder meeting or the resolutions of the board of directors; and

• other circumstances which may lead to a foreign investor's de facto control of a domestic company, including its operational decisions, financing, personnel and technology.

Foreign investors' M&A activities in relation to domestic enterprises include the following circumstances:

•  
• share purchase, including a foreign investor (a) purchasing the shares of a non-foreign-invested enterprise in China or subscribing to its the capital increase to convert it into a foreign-invested enterprise; and (b) purchasing the shares from Chinese shareholders of a foreign invested enterprise or subscribing to its capital increase.

• asset purchase, including a foreign investor (a) establishing a foreign-invested enterprise to purchase assets of a domestic company and operate such assets, or purchasing shares of a domestic company through such foreign-invested enterprise; and (b) purchasing the assets of a domestic company directly to establish a foreign-invested enterprise with such assets.

2.2 Content of Review

The national security review committee will review, approve or block a transaction based on the following aspects:

•  
• influence on national defense security, including influence on domestic manufacturing capabilities, services and related facilities and equipment required by national defense;

• influence on national economic stability;

• influence on basic social order; and

• influence on China's ability to research and develop key technologies for national security.

2.3 Review Procedures

(a) Review Body

The foreign investment security review committee will be guided by the State Council and led by the National Development and Reform Commission and MOFCOM, which will conduct reviews together with other agencies on as needed basis.

(b) Procedures

• Notification

Foreign investors shall make an application to MOFCOM when acquiring domestic companies. If the transaction falls into the scope of national security review, MOFCOM will submit the application to the committee for review within 5 working days. The Notice also permits the agencies of the State Council, national trade associations, competitors, suppliers and upstream and downstream enterprises to apply to MOFCOM for review of a transaction. 

• Review Process

  The review process starts with a "general review", and if a transaction fails to pass the general review, a "special review" will be required. If a transaction is deemed not have an impact on national security, the committee will send its review opinion to MOFCOM. Where a transaction is deemed to affect national security, a "special review" will be initiated by the committee and a security evaluation will be conducted and in the event of major disagreements, the committee will submit the transaction to the State Council for its final decision. After a final decision is made, MOFCOM will notify the applicant about the review result.

  During national security review, the applicant may apply to MOFCOM to amend the transaction plan or cancel the transaction. Where the acquisition of domestic companies by foreign investors has had or may have a material impact on national security, the committee shall require MOFCOM, together with the relevant agencies, to terminate the transaction or transfer relevant equities/assets or take other effective measures to eliminate the transaction’s impact on national security.

3 Comments

As mentioned in the beginning of this article, the requirement for national security review is already stipulated in the AML, however, there were no concrete rules in place until the newly issued Notice. In addition to the requirement for national review in respect of M&A activities, foreign investment in China must comply with the Catalogue for the Guidance of Foreign Investment Industries and, if required, complete anti-trust review in accordance with the AML. However, compared to developed countries, China's new requirement for national security review is not unique. For example, Australia has set up the Foreign Investment Review Board to review foreign investment projects, and the United States also has an intra-agency Committee on Foreign Investment in the United States, which reviews foreign investment in a US company that may result in foreign control or have an impact on national security.

While China's national security review may add additional burden and costs on foreign investors as well as uncertainty for M&A transactions in China, the Notice also provides a timeline for the review process and some level of transparency on the review procedures.

The Notice describes the scope of review in a broad stroke and some of the products or sectors are not sufficiently described or defined and this may give the review committee a lot of discretion. For example, the term "important agricultural products" are not defined and thus it is difficult to ascertain what kinds of products are covered, whether agricultural products include agricultural products processing, etc.

With respect to content of review, the Notice does not specify the criteria for evaluating influence on national economic stability and influence on basic social order. As the national review gets tested in real-life cases, there will likely be questions raised on the review process and procedures. It is possible that further explanations or regulations will be issued by the State Council or relevant agencies to make the national review more workable in the future.

If you have any questions or comments, please do not hesitate to contact us.

King & Wood

Xu Ping

Partner

Tel: 8610 5878 5012

xuping@kingandwood.com

Translators

“Mr. Zhang, you are a crook. You have misappropriated Joint Venture funds. I demand that you return the funds immediately.” — Irate China Investor

“尊敬的张先生，我们的外商对中国的财会操作不甚了解。他发现贵公司和合资企业之间存在着某种企业间的借贷关系。若贵公司能尽早把上述款项归还给合资企业，我们的外商将会十分感激。” — Translation by China interpreter (Translation as follows: Esteemed Mr. Zhang: Our foreign guest is unclear of Chinese accounting practices. He understands that there may have been certain inter-company loans between your esteemed company and the Joint Venture. Our foreign guest would appreciate if your esteemed company would at its earliest convenience return such funds to the Joint Venture.)

Many business primers in China lay great emphasis upon the use of independent translators. However, many others continue to believe it is not necessary. They are wrong.

With very few exceptions, the Chinese side will indeed need a translator even if the person with whom you are talking can speak English (or if you assume he speaks English).

I am reminded in such regard of the Belgian businessman who had conducted a number of meetings with a Chinese customer. The Chinese customer spoke some English himself and had his daughter acted as a translator as she had studied English at high school. The Belgian businessman was delighted about how quickly the Chinese customer had understood everything and his intense concentration. The Belgian would often speak for 20 minutes without interruption. At the end, the Chinese customer would simply agree. Curiously, most questions raised were on very simple issues or words. This was in fact not surprising as the Chinese customer probably understood virtually nothing, and his daughter may have only understood some of the opening statements.

There are no if's or but's — it is crucial to have your own translator in China.

However, that is not the end of it. As illustrated in the opening quote of this section, the translator wields enormous influence over the negotiations with the Chinese counterpart. Some foreign investors like the idea of a sherpa-like interpreter. This is someone who will take your words and then turn them into “acceptable polite Chinese wording”. For most investors, this is a poor solution. Most Chinese business people with whom you will meet can take it straight. I suggest only to use an interpreter if you believe the person: (1) is a better negotiator than you; (2) is clearer about your objectives than you are; and (3) has a better understanding of your company than you do. If not, it is better to use a translator. And if your direct manner does get you in trouble with the Chinese counterpart, well, it is likely that you are not destined to do business with one another.

It is also worth emphasising the word “independent”. If you are in a joint venture, it is probably important to have an independent translator at meetings with the Chinese partner.

In many cases, the foreign partner relies upon his Chinese manager to fulfil this role. In my experience, this will often lead to extremely negative results. Firstly, the Chinese manager is typically very keen to see a transaction occur. For this reason, the Chinese manager will often soften wording or provide explanations to a potential Chinese partner who you may deem unnecessary, or worse still, wrong. This does not mean that such behaviour is an act of bad faith, but he can often believe that his behaviour is in the best interests of the project. In very few cases does the China manager see a project dying as being in the company's best interests. However, experience has shown time and again that it would have been best to put a project to sleep rather than embark on an enterprise in which the partners have been misled to the overall strategy. Further, if a project does go ahead, it is often important for the shareholders to be able to have a direct discussion without the presence of local management. Direct confrontation is avoided in China even more than in the West. Therefore, having a person translating who may be part of the problem will at the very least affect the way in which the Chinese partner may wish to raise problems. (In some circumstances, the translation might twist the meaning of the original message. For example, when one tries to translate to his boss that the other side says “the General Manager is an incompetent fool”, he might have to translate it as: “They think the General Manager needs more support to improve the overall condition of the company”)

 Accountants
“Can't live with them, can't live without them.” — China project manager on accountants

Accountants are involved in almost every FIE project. Their scope of work in China will often surprise many. They are often involved in the selection of investment location, advising on tax rates, negotiation of tax subsidies, audit, financial due diligence, and ongoing advice on issues such as transfer pricing, customs duties and VAT planning, foreign exchange issues, tax incentives, and China and overseas tax returns, etc.

The Big Four accounting firms are all very well represented in China with offices in the major cities. In addition to the Big Four, there are also a number of smaller foreign accounting firms and local Chinese accounting firms.

Accounting firms normally provide services such as:
• audit and assurance;
• investment strategies;
• forensic services;
• risk management solutions;
• HR services;
• IPO services;
• mergers and acquisitions support;
• tax services; and
• transaction services.

Although it will be difficult to avoid accountants, it is important to find talented ones. It can be a mistake to leave them entirely to their own devices. Often, junior personnel will be assigned to work on the project, or in some cases, the accountants will only view documents to the exclusion of physical evidence or even common sense. This can be illustrated by the case of the USD 100,000 Ford Escort.

Case study: The USD 100,000 15-year-old Ford Escort
The client had purchased the entire business and assets of a Chinese target. At closing it was necessary to complete the stock take. During the stock take, it became clear that a vehicle which was in the books for USD 100,000 was not a large, expensive, new Mercedes truck but rather a small, old Ford Escort.

The client had not conducted a physical stock take of the assets but had rather relied on the accountant's financial due diligence, which in turn relied upon the books of the company. Accordingly, no one had looked at the physical assets. The Ford Escort had entered the books
as a payment for a debt of USD 100,000, ie the target's customer did not pay and the company took his car.

The business development manager of the foreign company was now in a dilemma. It was a multi-million dollar deal, and in the scheme of things, the USD 100,000 was a relatively small amount. However, headquarters (as headquarters are prone to be) would love to unravel
a whole transaction based on a minor asset. The headquarters would be unlikely to know whether a plant in China is worth USD 1 million or 10 million, however, anyone would know that a 15-year-old Ford Escort is not worth USD 100,000. To add insult to injury, when the client notified the accountant of the problem, the accountant advised that it could indeed be a problem and recommended that they conduct a second financial due diligence on this issue — seemingly oblivious to the fact that they had done a first due diligence and that the case was at the stage of closing.

 Lawyers
“Lawyers are like rhinoceroses: thick skinned, short-sighted, and always ready to charge.” — David Mellor

Corporate lawyers are basically consultants. However, it is wise to never refer to a corporate lawyer as a consultant unless you wish to irritate him. If a consultant tells the corporate lawyer that he is a consultant “just like you”, it is likely that the corporate lawyer's face will contort into a pained look similar to that of a policeman being told by a prison guard that they are both in “law enforcement”.

In many cases the services of lawyers can overlap with those of consultants and accountants.

The services lawyers typically provide in China M&A deals include:

• conduct legal due diligence of the target company and/or assets;
• structuring the transaction;
• drafting contracts;
• assisting in negotiations of the transaction documentation (joint venture contract, assets transfer agreement, articles of association, etc);
• accompanying the project’s approval process; and
• providing ongoing support.

It is important for the business teams to properly manage lawyers within a deal. Many lawyers wish to restrict themselves to providing narrow, pure legal advice. In China transactions much of the lawyer's value should be experience gained in other transactions. In addition to legal advice it is important for the lawyer to provide the client with an independent assessment of the transactions risks and the context of such risks.

Summary

China projects do not run themselves. The assembling of a transaction team is a key factor in completing a successful project. Experience has shown that if the in-house team has high level support from within their company then they will have a far better chance of success and the project will be able to proceed much more quickly.

The in-house team will in most cases need external support. Selecting and managing the external consultants is extremely important for the project's success. Ideally the external team should provide practical insights as to how best to overcome issues and minimize risk in the project.

The unsuspecting foreign investor will be surprised to find how helpful everyone is in China. Indeed, it often seems that China's biggest sector after manufacturing is consulting service in relation to China. A Google search of “China consultants” resulted in over 20 million results.  Googling “ethical consultants in China” resulted in two million results — more than expected!).

One of the reasons that multinationals do relatively well in China is the depth of their management. Medium-sized companies will often need external support for their China projects, and there are so many consultants to choose from in a myriad variety of types and sizes. The usual suspects (ie types of consultants) are listed below.

The China Consultant — Jack of all Trades
“Russia is a riddle wrapped in a mystery inside an enigma.” — Winston Churchill
“China is much more complicated than that!” — China consultant

The China Consultant can be a blessing to an inexperienced China investor. However, it is extremely important to choose one that understands you and what you wish to do. Further, it is important to ensure that the investor remains deeply involved in the project — responsibility cannot be outsourced. If it is your investment project and it fails, it will not help to blame the hired hands, ie the consultants.

The generalist China consultant — the “zhongguo tong” or old China hand can play an important role.

In many cases, these consultants have little knowledge (many people believe the sentence could end at this point) far less than the client of the industry in which the client is operating. They rely to a great degree on their “China knowledge” and “guanxi”.

China is clearly different in many ways from Europe or the US. However, it is not the unfathomable enigma made out by many China consultants. Naturally unscrupulous consultants wish to make China more mysterious than it actually is in order to maintain their role in a project. If a consultant states to you that he is a crucial part of the project (as opposed to becoming crucial by doing a good job), well then, it is probably time to find a different consultant.

However, it would be unfair to dismiss the China consultants out of hand. Consultants can and do play important roles. It is important for foreign investors to select a consultant with whom they feel comfortable and who can cover manpower or expertise shortcomings within their own organization.

Crucial criteria for selecting a consultant include:

The consultant has your interests at heart - For many consultants, it is not the success or failure of the project that matters, rather, it is whether the project proceeds that is important. In many cases, unscrupulous consultants prepare feasibility studies which have best case scenarios based on the assumption that “if every Chinese added one inch to his shirt tail”, and worst case scenarios which are only slightly less pessimistic, such as “if every Chinese added two-thirds of one inch to his shirt tail”.

Case study: The Intermediary
In the Harvard Business Review on Doing Business with China (Graham, John L. and Lam, N. Mark, “The Chinese Negotiation”, in Harvard Business Review on Doing Business in China (Boston MA: Harvard Business School Press, 2004).), an article entitled “Chinese Negotiation” by John L. Graham and N. Mark Lam lays great importance on the role of the “intermediary” (zhongjian ren) (In Chinese: 中间人). Basically the intermediary is a person who can bridge the two sides and intercede when there is conflict. The authors advise that the intermediary plays an indispensable” role in such discussions:

“Only a native Chinese speaker can read and explain the moods, intonations, facial expressions, and body language Chinese negotiators exhibit during a formal negotiation session. Frequently only the zhongjian ren can determine what’s going on. … the zhongjian ren can step in because he is an interpreter not so much of words as of cultures.” (Graham, John L. and Lam, N. Mark, “The Chinese Negotiation”, in Harvard Business Review on Doing Business in China, p 41)

Experience, at least mine, has shown that if in order to communicate with the Chinese partner on the other side you need someone to analyse his “moods, intonations, facial expressions, and body language”, well, it is probably time to look for another Chinese partner who is less difficult to deal with. One should also bear in mind that the mission is not accomplished with the signing of a contract — it is the establishment of a successful project. At the time of project implementation, the zhongjian ren will no doubt be off brokering deals elsewhere while you will be sitting with Chairman Liu, trying to work out what he means when he crosses his arms and speaks with a slightly higher than normal lilt.

However, I may be wrong as John L. Graham and N. Mark Lam even helpfully provide an example of intermediary “magic”:

“Indeed, we have seen more than one zhongjian ren successfully deal with divisive disagreements. The following is one such case.

A vice president of a New York-based software company went to Beijing to negotiate a distribution contract with a Chinese research institute. Having attended meetings arranged by the intermediary — a former senior executive with the institute — the VP was pleased with the progress during the first two days. But on the third day, the two sides became embroiled in a fruitless debate over intellectual property rights. Feeling they were losing face, the Chinese ended the meeting. That night, the VP and the China country manager met with the intermediary. The following day, the intermediary called the head of the institute and worked his magic. In the end, both sides agreed that the intellectual property rights were to be jointly owned, and the contract was signed.” (Graham, John L. and Lam, N. Mark, “The Chinese Negotiation”, in Harvard Business Review on Doing Business in China, p 42)

And that indeed sums up the problems with using intermediaries in China.

Intermediaries normally convince the unsuspecting foreigner to agree to what the Chinese counterpart wants. The above passage even admits that the intermediary was “a former senior executive with the institute". It is unlikely that he would switch allegiance to the US company based on some nice dinners (according to the authors, “Expensive meals in nice places are key”). In my experience, the intermediary (especially one with links to the Chinese partner) grants the Chinese partner an enormous advantage in negotiations. The intermediary will allow the Chinese side to know what the foreign side is thinking and will normally push for the easiest way to an agreement. This is normally to convince the foreign partner that “this is China” and to agree to the proposal on the table.

The “magic” solution outlined above was that the New York software company agreed to joint ownership of the intellectual property rights of its software with a Chinese distributor. Leaving aside the fact that it would seem strange to grant a distributor intellectual property rights, the even greater question is: what was the “magic”? Did the Chinese distributor want sole ownership of the software? I do not think I would grant a distributor ownership of software.

The consultant is realistic about China and himself - Many China consultants have a vested interest in making China a mysterious, unfathomable, and almost dangerous place. Only with their guidance and even more importantly, their highly placed contacts, could your medium-sized company hope to navigate the behemoth which is China. This is obviously over the top. Some things are different in China, but most things that make sense overseas also make sense here. Contacts do help as is the case everywhere, but they are not the only factor.

In addition, one should be wary of consultants who claim “they have unrivalled contacts in China”, “my father was a foreign minister in post-liberation China” (indeed the writer has met three consultants who have made this claim — but they well have been telling the truth as they all proved to be crooks and may have been related) etc.

The consultant should not care too much - Naturally it is important for your consultant to care but it is also important that he does not care too much.

This can be best illustrated by the following case:

Case study: There is no place like Home

A company from Austria was interested in manufacturing cane chairs in China. Basically, the design was made in Austria. Cane would need to be sourced in China and some assembly work was required. The production would then be exported. All in all, a small project.

As the company was small and had little overseas experience, it came across an Austrian entrepreneur living in China. This Austrian entrepreneur had a factory located in Xiaoshi, a small village in Liaoning province in the Northeast of China. The Austrian entrepreneur had convinced the Austrian company that he was an extremely successful businessman in China and was running a number of factories very successfully. That this successful businessman was willing to take time out of his hectic schedule to assist in locating an ideal place to assemble some cane chairs did not seem to raise any alarm bells.

In any event, consult he did. The conservative Austrian company requested a feasibility study on the location of the facility. The Austrian consultant went off and conducted his investigation. Now, a layman may think that the obvious location for a small assembly plant for export would be near a port, a railway connection or some other form of transport. Alternatively, it would make sense to have the facility located near the raw materials.

You would be wrong. The feasibility report concluded that the perfect location for the assembly would be Xiaoshi — despite being located far from rail, sea or port; despite being four hours from the nearest airport; despite being possibly one of the only places in China where bamboo refuses to grow.

However, if the consultant surprised with the general location of the proposed facility, he was able to exceed all expectations in relation to the level of specification. The consultant had been able to pinpoint a factory on a street near his current factory. Further good news abounded in the feasibility study. In addition to finding an optimal assembly location, the consultant had been able to drum up support with the local party secretary. The report proudly stated that “Xiaoshi’s party secretary supports the establishment of a cane chair production facility”. In addition, he would give his support to the Austrian company to use the state-owned factory provided the Austrian company was able to meet certain investment and tax requirements. The consultant was also willing to take a share in the new venture to “smoothen things”.

The Austrian company decided to set up a simple assembly plant in Suzhou and has been successfully assembling and exporting chairs for several years without high-level political support.

Having an export manager deal with a China project on a part-time basis will mean that the project may have a lower priority than it deserves. Having a middle manager deal with a China project on a full-time basis and having his destiny interwoven with the China project (i.e. no China project = no job) may mean the deal will proceed regardless of whether it makes sense or not.

In the author's experience the most successful China project teams are indeed teams rather than individuals. Suitable team members will typically consist of an in-house team consisting of an executive-level member, a business development manager, an in-house lawyer and a technician; and normally external support including lawyers, accountants and consultants.

In-House Team

(1) Executive
Often in China, it is difficult to close a deal without the assistance of an executive-level negotiator from the head office. It can often be a mistake to bring such persons too early into the game as this demystifies them. Better to bring the high-level negotiator to close the last remaining open points rather than waste him on small wording issues.

(2) Business Development Manager/Project Manager
Projects without a dedicated project manager or business development manager tend to proceed slowly. Ideally, this person will not be the person to actually implement the project if it is a joint venture. This may appear at first glance to be counter-intuitive. However, experience shows that although a dedicated project manager is good, one that is too dedicated can be very bad.

Project managers who end up implementing the project (i.e. as General Manager) will tend to adopt a position of compromising too easily on important issues to the company and digging in the heels for items that, although less critical from a corporate view, may impact upon the General Manager. If the candidate for the General Manager is already clear, then it is useful to have him or her involved but not leading the discussions.

Case study: Our Friend François
An example of such an issue was with a French chief representative who was negotiating a joint venture for his company. François saw his very career being entwined with the formation of the joint venture as he would be the General Manager. The project was to be a 50/50 joint venture due to legal restrictions.

In the initial letter of intent, the parties had agreed that the French side would nominate the General Manager. However, as one may expect, during the actual negotiations of the detailed joint venture documentation the Chinese side wished to have a “veto” over the actual appointment. Sacré bleu! The Chinese side was sensitive to François’ obvious discomfort with the proposal which appeared to him to be a thinly veiled attack.

In order to smoothen our Gallic friend François’ ruffled feathers, the Chinese explained that it was not that they were against François as General Manager. No, François was their friend. No, François was a competent man. No, the problem was that the Joint Venture was to last for 20 years and their concern was whether François’ successor would be equally competent. François’ response (unfortunately heartfelt) was that they should not worry. It was clear that after his term as General Manager, he would return to France and have a board position in the headquarters and be responsible for Asia. Accordingly, the Chinese partner could rest assured that François would still be involved. It was a little difficult, but I felt it necessary to take François to one side and explain to him: “1. The Chinese partner is interested in doing the project with the company, not with you; and 2. they were only being polite — they do not really think you are competent.”

(3) In-house lawyer
A much maligned breed. For many project teams, the in-house lawyer represents the worst nightmare — the lawyer you cannot fire.

However, in-house legal counsels will often play an important role in a China project.

Their main advantages are: (1) they have a good understanding of the foreign company doing the project (i.e. what is feasible and what is not); (2) they can play an important role in ensuring that the proper headquarters’ resources are brought to bear as required; and (3) an often underrated advantage is that they are able to ensure that outside counsel remain focused on the project.

When the legal counsels are good, they can be very good for a project. However, occasionally one comes across in-house counsels that seem to block everything. As the Chinese saying goes: “A man who cannot say yes is useless, a man who cannot say no cannot be trusted” (不能说“是”的人没有用；不能说“不”的人信不过。). Some in-house lawyers from headquarters fall within the “cannot say yes” category.

There is one tried and true solution to such a dilemma — invite the in-house lawyer to attend negotiations in China. Most China project negotiations do not occur in metropolitan Shanghai or Beijing but in relatively remote areas. One trip will normally be enough to change the in-house lawyer's attitude from “No way, this is a crucial issue” to “OK, well if you cannot negotiate that point, I understand it is difficult to second guess negotiations when you are thousands of miles away (please God, do not make me go back to that hell hole)”.

(4) Technician
Almost all China projects have a technical or technological element. The technology is normally an integral part of the potential risk as well as being crucial to the project's success. Despite this almost all joint venture projects are negotiated without the participation of technicians. Input from technical staff is crucial in determining how to protect technology, assess what technology should flow into China, and also crucially, how to transfer technology to China.
 

For many companies approaching a transaction, due diligence is a tool to confirm
compliance or to seek confirmation that their project is not excessively risky. In the
context of an acquisition in China, this is the wrong approach. Chinese companies are
used to informal arrangements; as a result, non-compliance issues may arise in the
fields of employment and social contributions, tax, licensing and intellectual property,
among others. However, if a Chinese company raises no compliance issues, it is
almost certainly not a viable option for a project - the target does not need the acquirer
and the acquirer is unlikely to be able to afford the target. When properly performed, due
diligence should uncover problems and compliance issues, but should go further and
provide a plan - including price reductions, corrective measures and other steps - that
allows for successful implementation.

A foreign company's ultimate decision maker may see little immediate opportunity in
China, being reluctant to move hastily in a risky market and making full compliance a
prerequisite for a deal. However, a visit to China can turn the most cautious chief
executive officers into the most over-zealous converts. Due diligence plays its part in
contextualizing a particular opportunity in the most practical terms.

Types of due diligence

A foreign investor normally starts conducting due diligence as soon as a letter of intent
has been signed. This work is conducted in various ways:

• Legal due diligence is carried out by law firms, which check the legal status of the Chinese target, including its ownership structure, assets, operations and staff.
• Financial due diligence is carried out by accountancy firms to check compliance with accounting and financial requirements, and may overlap with a law firm's work.
• Investigatory due diligence is conducted by private investigation firms to check the good-faith basis of key management or business operations. This is normally necessary only in sensitive cases or to address serious concerns that are brought to light by financial or legal due diligence.

Environmental due diligence is increasingly common. A law firm's research usually
determines whether the target has the necessary environmental permits and
operational licences, but it is based on documentation and interviews. In some
cases a foreign investor also requires a technical assessment of a factory or other
asset in order to assess its level of compliance. For example, soil sampling can
determine whether the land involved in the deal is contaminated.

Procedure

The due diligence process follows an initial discussion with the client to gain an
understanding of its industry, project and intended goal.

Strategy paper

• A strategy paper should give a basic legal opinion on:
• the restrictions on the intended business (eg, whether a wholly owned foreign enterprise can be used and which operational licences are required);
• the potential advantages of incorporating a new company, including any preferential treatment available to a foreign investor on this basis; and
• operational requirements.
   

Preparation for fieldwork

Preparation for fieldwork should involve:

• liaising with other due diligence teams to minimize disruption to the target's organization and business;
• providing a list of documents for the target to prepare in advance; and
• making clear to the potential partner that cooperation with the due diligence process is a precondition of the deal.

Fieldwork

In the case of a Chinese target, due diligence that is confined to data rooms and document review is highly unlikely to result in useful findings for the acquirer, whereas direct research can be remarkably revealing. Ideally, fieldwork should involve:

• collecting documentation;
• interviewing members of the target's management, who may be surprisingly frank
• about the basis of its operations;
• cross-checking documents and visiting the relevant authorities, including the Real
• Estate Bureau, the State Administration for Industry and Commerce, the
• Commission of Foreign Trade and Economic Cooperation and the courts; and
• meeting stakeholders, including banks, customers and employees.
   

Picturing the target - an acquirer's checklist

In order to make a balanced decision about a transaction, an acquirer should have an
overview of:

the target's structure, including:

• parties' agreements or board resolutions on amendments to the target's articles
• of association;
• amendments to the shareholder agreement, if any;
• business licences; and
• an itemization of the parties' investment in the increased registered capital;

the basis of the target's operations, potentially including:

• approval from the State Administration of Foreign Exchange;
• production or product licences;
• environmental protection agency approvals;
• pharmaceutical licences;
• certification of tax registration;
• land use rights and building certificates; and
• documents relating to equipment and machinery;

the target's contractual obligations, including:

• agreements between the target and its shareholders;
• loan agreements;
• major supply and sales contracts; and
• documentation on product distribution, technology, employees and accounts
• receivable; and

 the target's claims and potential liabilities, including:

• pending outstanding debts;
• claims or awards pending with courts or arbitration bodies;
• discrepancies in audited accounts; and
• ongoing investigations by government authorities.
   

Potential problems

A would-be acquirer must be prepared for difficulties in areas that might be taken for granted in a transaction outside China, and an examination of potential problem should start with the basics - it seems unlikely that a foreign investor would buy a nonexistent company, but this has happened. Beyond disaster avoidance, an investor must consider whether the problems are irreparable or whether realistic solutions can be found.

Land use rights and buildings

Many Chinese companies operate on the basis of an informal arrangement with local
authorities. An apparent owner may see no problem with pursuing a deal even if it has
only a short-term, unenforceable buy-back agreement with the local municipal
government, which remains the target's actual owner. Land or buildings may be
mortgaged and the company may operate on the basis of allocated rather than
commercial land use rights.

Assets

In addition to the issue of actual ownership, an assessment of assets must consider
customs supervision, production know-how and third party rights (eg, mortgage or retention of title).

Operational issues

Acquirers should be aware that state-owned enterprises can obtain licences for
commercial activities that are not open to foreign-invested enterprises; thus, the
involvement of a foreign entity may result in licences being withheld or not renewed.
Most companies do not apply Western standards of environmental performance and
different standards apply to different enterprises.

IP rights

Although the approach to intellectual property in China has been changing fast in recent
years, many Chinese targets value IP rights far less than a typical foreign acquirer
would do, and may not even price them into the transaction. However, this approach
demonstrates a less than rigorous approach to IP issues and often spells trouble. It is
not unknown for a Chinese target to seek to sell technology in which it has no
proprietary rights, and trademark and patent registrations must be cross-checked with
official records.

Employment

Few Chinese companies can accurately claim to comply perfectly with labour
obligations. In one transaction the due diligence report found that 220 of a target's 350
workers were classified as disabled, which enabled the company to take advantage of
the value added tax exemption for certain enterprises employing disabled people as
more than 50% of their staff. However, none of the employees actually performed work
for the company; rather, the company's workers were found to be employed by a third
party.

Comment

Although one purpose of due diligence may be to act as a corrective to 'deal destiny', a
review of the potential pitfalls for M&A projects in China might be enough to dissuade
some potential overseas investors entirely. Not all problems are surmountable and not
all projects should proceed. Some risks may be legally remote but difficult to repair, and
if a target is seriously flawed, the acquirer must be prepared to look elsewhere.

However, many projects fail - or stall for long enough to allow a rival to swoop - because
due diligence results are not read in context or because it is easier to list noncompliance
issues than to remedy them. Firm but fair dealing with the target in the due
diligence process and a clear message about the need for cooperation ensures that
the process and results can be used properly: to reduce risk and optimize the legal
structure of a deal. In this market in particular, it pays to be prepared.

1 Foreign Investment More Welcomed in Certain Sectors

According to China's economic development needs and planning goals, foreign investment in high-end manufacturing, high-tech, modern services, new energy, energy efficiency, outsourcing, and environmental protection industries will be welcomed while polluting or energy-gorging projects and industries running at overcapacity will not be as welcome. Based on the above guidelines, the Foreign Investment Industrial Guidelines Catalogue issued in 2007 will be revised.

In addition, foreign-funded projects in the “encouraged” category of China's foreign investment catalogue will benefit from lower land prices which will be discounted 30%. These policies are intended to facilitate China's continued economic growth by targeting foreign investment in industries higher up in the economic value chain and permit environmentally sustainability.

2 New Policies With Geographic Focus

Foreign enterprises are encouraged to increase investment in China's central and western regions with a particular focus on environmentally sound and labor-intensive businesses. This will be accomplished through tax incentives, policy support and in the development of streamlined procedures for foreign companies that relocate operations from the coastal regions to the center. Incentives will include potential matching funds, technical support, improved administration and other favorable policies. Based on revisions to the Foreign Investment Industrial Guidelines Catalogue, the Foreign Investment Dominant Industrial Catalogue in Central and Western Regions will be further revised.

3 More Open Domestic Capital Markets

Foreign investors are encouraged to participate and acquire domestic enterprises through restructuring or M&A. In particular foreign strategic investors are invited to participate in domestically listed companies, which used to be restricted for foreign investors. Foreign companies will also enjoy standardized and streamlined rules for investment in domestic securities and in corporate M&A moves. M&A transactions between foreign parties should become more streamlined, but a national security examination mechanism will also be established to review foreign M&A operations in China. Qualified foreign invested companies will also soon be allowed to list and issue corporate bonds or medium term notes in China.

4 Improved and Streamlined Operational Incentives

Multi-national companies will be encouraged to establish regional headquarters, R&D centers, financial management centers, and other critical management and operational centers in China. Imports for scientific and technological development from qualified R&D centers will be exempt from tariffs, import VAT and goods and services tax by the end of 2010 under the guidelines.

The approval procedures for foreign investment will be streamlined and the scope of approval and authorization will be reduced. Examination and approval competency for foreign investment will also continue to devolve to lower governmental levels whereby encouraged investment below $300 million for encouraged and permitted projects will be examined by local authorities rather than national ones. The devolution of approval competency for most projects will simplify and speed up the approval process for foreign investors.

In addition, the procedures on settlement of foreign exchange capital funds for foreign investment companies will be simplified. With respect to foreign investment companies operating legally but unable to meet their capital contributions requirements as a result of a tight budget, their deadlines for capital contributions may be extended.

Through these new guidelines, China reiterates its support for foreign investment and could be a response to some complaints that China was reversing its foreign investment policies in the wake of several high-profile matters involving Google and Rio Tinto. These guidelines widen market access to foreign investors and better direct the inflow of foreign capital while also improving China's global competitiveness and promoting more efficient foreign investment into economically vital areas. Naturally detailed rules to implement these initiatives are still to come out.
 

Please note that this entry is provided for general information only and may not be used as a substitute for legal consultation.
 

Without the Measures, the existing Partnership Enterprise Law itself does not allow foreign investors to directly invest in partnerships due to a provision which says such circumstances will be subject to administrative measures to be issued by State Council. Though with such restrictions, international PE/VC firms still appear to prefer using limited partnership as the form of RMB fund, and try the approach of setting up a foreign invested company acting as the general partner and raising fund from domestic investors, which proves practicable in some areas of China. Nonetheless, due to the foreign exchange control in China, a limited partnership cannot receive substantial funding from foreign investors even in such an indirect way.

The Measures generally allow a foreign investor to act as a general partner or limited partner of a limited partnership, but it is still too early for PE/VC firms to celebrate the opening of door. The Measures indicates that for foreign enterprises or individuals setting up partnerships in China with the main business of investment, special laws or regulations in this regard could apply. According to the answers of the Legal Affairs Office of State Council explaining the Measures to journalists, the authorities has not figured out a clear position on partnerships with the main business of investment, such as venture capital enterprises and private equity funds etc., and thus the relevant wording in the Measures is flexible. As a general practice in China, the implementation of the Measures will require detailed rules, which may address this issue further.

The Ministry of Commerce and its local counterparts (“MOC”) has been the main approval authority for foreign invested enterprises for decades, but the Measures take a different approach for foreign invested partnerships (“FIP”). An Application for the establishment of an FIP shall be submitted to the local administration of industry and commerce as authorized by the Sate Administration of Industry and Commerce (“AIC”). MOC will only be notified of the registration information upon the establishment of an FIP. An FIP is still subject to foreign investment industrial policies, including the Foreign Investment Industry Catalogue, and the AIC will review an explanation on compliance with foreign investment industrial policies as part of the application process. We would like to put a question mark on the consistency between AIC and MOC in applying industrial policies to FIPs and other foreign invested enterprises respectively, and speculate that this could trigger the involvement of MOC in approving FIPs.

I. Franchising Trends in China

A. Trend 1: Franchising of Services Derived from Product Trademarks

Generally, franchising is a complete and compact business model that focuses in one particular limited industry area. For example, "Ten Fu' s Tea," is a tea shop where people may taste tea before they buy, but it is not a tea house with tea tasting “services". In franchising, very few companies mix product trademarks with service marks. Mostly, companies prefer to distinguish between the two, for example, IBM was mainly a computing brand, but its after-sale service brand is "Blue Express."

However, franchising in China recently saw the development of a new trend which extends the product trademark to the service sector. In other words, franchising may extend from the manufacturing industry to the service industry. For example, Shanghai Jahwa's mark "HERBORIST" is a trademark for high-end cosmetics that can only be bought in company-owned stores. This limitation on the brand is a clear message to consumers that only company-owned shops sell that product line, and any other channel where the product line is available is not officially authorized. By doing so, the company greatly reduces the possibility of its products being counterfeited and crosses from the manufacturing phase to the retail phase. Moreover, it ensures the quality of the product line, and that the brand will always be connected with "high-end" products. Once this brand acquired market recognition, Shanghai Jahwa opened the "HERBORIST SPA" salons through franchising, which extends the brand from a product brand to a service brand as well.

B. Trend 2: Franchisees dissatisfaction with dependency

In order to maintain quality, franchisors often intervene into operations of the franchisees and take strict control of the franchisees' management. The franchisors often set various restrictive provisions in their franchising agreement and franchisees are often controlled or restricted by the franchise agreements with respect to branding activities, management models, supplies and so on, and must give up control in strategic decisions. For example, franchisees do not have flexibility to adjust its operational model to suit local customers' needs. As a result, although a franchisee is legally an independent owner, it is in fact a subordinate of the franchisor. As the franchisee improves over time, it becomes obvious that the franchisees will feel uncomfortable with their obligations on payment of royalties, advertising fees, and training fees to the franchisor.

During the current economic downturn, when a company wishes to expand, the first and foremost issue is looking for capital. Many multinational companies have since decided to expand into the Chinese market. Under such circumstances, multinational corporations often try to work with strong local Chinese companies under franchising arrangements. However, a franchisee who only obtained territorial authorization is often dissatisfied with its subordinate position. This is particularly apparent if the franchisor has to rely on a franchisee' s financial support and distribution networks. The franchisee will then desire a stronger position which may lead to future conflict.

This situation is more likely during the current financial crisis as more franchisors need to rely on the franchisees' financial support. This new imbalance may cause a franchisee to gradually deviate from the franchisor's control, the unified management standards, and quality requirements. The faster a franchisor expands his franchising businesses, the bigger a franchising territory is, the harder for the franchisor to control franchisees. Any deviation from the spirit of franchising will ultimately damage the franchised brand, and result in losing its market completely.

As this series continues, we will examine how franchisees exert influence on franchisors and provide suggestions for franchisors to maintain control.
 

Before the issuance of such a Circular, the above-mentioned question has for a very long time confused not only foreign investors, its lawyers, and other consultants, but also some local officials of SAFE partly due to the reason that SAFE did not clarify this question by issuing an official and universally-applicable rule. As a result the answer to this question has to depend, to large extent, on the local regulatory practice. Not surprisingly, in practice, some local offices of SAFE held a view that a FIE should not be allowed to exchange the foreign currency from its capital account into RMB for purposes of re-investing in China on the grounds that the foreign currency deposited in such account had been specially approved to satisfy the defined project as described in the business scope. In the meantime, some others officials held different views and allowed the FIE to settle the foreign exchange into RMB to satisfy the needs of re-investing in China. This is particularly the case where a local government is thirsty for foreign investment and it may be driven to take a more flexible policy.

Now, with the promulgation of the Circular, the door to direct re-investment by FIE(s) using the RMB settled from its foreign exchange capital account in China is closed. If a FIE happens to come upon a good investment opportunity, it will have to use its accumulated RMB profits or income or borrow RMB from domestic banks.

As is known in recent years, international “hot” money has unnerved the Chinese government which has thus taken a series of measures to cope with the issue. Without doubt the new rule is intended to strengthen the administration of foreign exchange flow and curb the inflow of hot money. However while it may contribute to the strengthening of its foreign exchange administration and the stability of its economic growth, it may also add the cost of making re-investment by foreign investors through their FIE(s) in some cases more difficult from a commercial perspective.
 

Conditions to be Considered - the regulations introduce factors for the authorities considerations such as whether an import will unfavorably influence the PRC domestic industry’s development, adverse affect upon public morality or environment.

Validity Period - the amended Article 9 states that the validity period for the Proposal for Technology Import License will be set within the range of one to three years. As the previous law did not set limits it is not clear what this restriction will mean in practice.

Procedural Changes – the new regulations require on-line registration with a MOFCOM website before an applicant can collect a Technology Import License. More importantly, contracts which include royalty payments require the technology importer/exporter to make a recordal within 30 days after the base figure for the royalty has been determined. This requirement appears to be an on-going requirement for subsequent years.

Requirements in respect of free technology transfers have been relaxed. Under current law the technology importer or exporter should re-register any amendment to a free technology import or export contract. The June 2008 amendments simplify this by requiring the technology importer or exporter to comply with an amendment recordal procedure rather than re-registering. However, the current practice of the vast majority of companies in China – i.e. doing nothing – is simpler still. However, a failure to follow up properly will make taking legal action against a breaching importer more difficult still.