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

Establishing a Nationwide Filing System

While the Pilot Rules only applied the filing requirement to EIEs with a capital amount of RMB 500 million or above, the Notice has removed this threshold and subjects all equity investment enterprises to filing.  Existing EIEs are required to file within three months of the promulgation of the Notice (i.e. November 23, 2011) and newly-established EIEs should file within one month of completing their registration with the Administration for Industry and Commerce, unless:

• the EIE has registered as a venture capital enterprise pursuant to the Interim Management Measures on Venture Capital Enterprises; or
• the EIE is funded and established by a single entity or natural person, or by two or more investors that are wholly-owned subsidiaries of the same entity.

The filing authority is divided into two levels depending on the scale of the EIE:

• for capital equal to or more than RMB 500 million or its equivalent in foreign currency (including paid-in capital and committed capital), filing should be made with the NDRC, which takes up to 40 working days; and
• for capital less than RMB 500 million or its equivalent in foreign currency, filing should be made with an authority appointed by the provincial government (we believe that such filing authority will usually be the provincial counterpart of the NDRC), which takes up to 20 working days.

The Notice itself does not impose substantial sanctions for failure to follow the filing requirements (the only sanction provided in the Notice is that the NDRC will publicly announce non-compliant EIEs).  However, we understand that, in practice, negative consequences may include being prohibited from investment by social security funds and possibly underlying pressure and constraints from the government during its operation and for establishment of new funds in the future.  

Regulating the Establishment, Fund Raising, and Investment Operations of EIEs
 
The Notice provides that EIEs may take the form of a limited liability company, a company limited by shares or a partnership by following the PRC Company Law or PRC Partnership Law.  The capital of an EIE may be committed capital to be paid in installments during the operation of an EIE according to its articles of association or partnership agreement. 

Fund raising of EIEs is restricted to private placement to qualified investors capable of risk assessment and tolerance.  Solicitation to unspecific investors via public channels, i.e. through media, seminars, text messages, etc., and promising a fixed return is forbidden.  EIEs investment is limited to equity of non-publicly-traded companies and unused cash should either be deposited in banks or be used to purchase investment products of fixed income such as treasury bonds.  

Improving the Risk Control System

For risk control purposes, the Notice prohibits an EIE from providing a guaranty to companies other than those it invests in and provides that affiliated parties must refrain from voting for an EIE's investment in affiliated enterprises.  The Notice further provides that assets of EIEs should be entrusted to an independent custodian institute, unless all investors agree to a waiver of such entrustment.  Where the entrusted management institute of an EIE is a foreign invested company, assets of such EIEs must be entrusted to a custodian institute with independent legal status in the PRC.

Clarifying Basic Duties of an Entrusted Management Institute

The Notice requires that, where EIEs adopt the form of entrusted management, the entrusted management institute should prepare and implement the investment plan, manage invested enterprises, provide such enterprises with value-added services, disclose to the EIE relevant operational information, and prepare accounting statements and reports to EIEs.  If the entrusted management institute acts against the interests of investors (i.e. using the EIEs' assets for the benefit of a third party), investor may request the entrusted management institute to resign.

Establishing EIEs' Information Disclosure System

The Notice requires EIEs provide investment operation information to investors as well as submit annual business reports and audited finance reports to the filing authority within four months of the end of each accounting year and report to the filing authority any of the following significant events during its operation within 10 working days from its occurrence:

• amendments to the articles of association, partnership agreement or entrusted management agreement of the EIE or entrusted management institute;

• increase or decrease of the capital or external financing of the EIE or entrusted management institute;

• division or merger of the EIE or its entrusted management institute;

• alteration of custodian institutes or entrusted management institutes including senior management changes or other material changes; or

• dissolution or bankruptcy of the EIE, or the EIE's assets having entered into receivership.

(Written By Jiang Qian)

《通知》规定投资者为集合资金信托、合伙企业等非法人机构的，应打通核查最终的自然人和法人机构是否为合格投资者，并打通计算投资者总数，但投资者为股权投资母基金的除外。对于投资领域，《通知》规定股权投资企业的投资领域限于非公开交易的股权，闲置资金只能存放银行或用于购买国债等固定收益类投资产品；投资方向应当符合国家产业政策、投资政策和宏观调控政策。股权投资企业所投资项目必须履行固定资产投资项目的合规管理程序。

在健全股权投资企业的风险控制机制方面，《通知》要求股权投资企业应当合理分散投资，其资金不得用于为被投资企业以外的企业提供担保；投资关联企业的，投资决策应当实行关联方回避制度；股权投资企业及其受托管理机构的公司章程或者合伙协议等法律文件，应当载明业绩激励机制、风险约束机制。《通知》进一步明确了股权投资管理机构的基本职责，并要求股权投资企业除需向投资者披露投资运作信息外，应于每个会计年度结束后4个月内，向备案管理部门提交年度业务报告和财务报告。在投资运作过程中发生重大事件的，应及时向备案管理部门报告。在对股权投资企业的备案管理方面，《通知》要求股权投资企业除两种情形外，均应当在完成工商登记后的1个月内，申请到相应管理部门备案。股权投资企业的受托管理机构应当公平对待其所管理的不同股权投资企业的财产，不得利用股权投资企业财产为股权投资企业以外的第三人牟取利益。对不同的股权投资企业应当设置不同的账户，实行分账管理。

《通知》要求备案管理部门建立健全股权投资企业备案管理信息系统、社会举报、定期与不定期检查、向社会公告等制度。
 

 To test the water, Shanghai will first implement the Pilot Program among the private equity investment funds ("PE funds") registered in Pudong New Area of Shanghai. One of the highlights of the Pilot Program is the introduction of QFLP into the current foreign exchange administration system to encourage foreign investment in China-based PE funds.

I. Foreign Exchange Control

Commonly, the general partners ("GPs") of a PE fund subscribe capital contribution equal to 1%-3% or more of the total capitalization of the fund. In the past, some foreign PE funds carried out PE investment in China by setting up a foreign-invested enterprise ("FIEs") which would then establish a PE fund in the form of limited liability partnership and would serve as the GP of the fund. However, these GPs often faced practical barriers when making capital contribution. According to the Notice of the General Affairs Department of the State Administration of Foreign Exchange on Relevant Operating Issues Concerning the Improvement of Administration of Payment and Settlement of Foreign Capital by Foreign-invested Enterprises ("Circular No. 142"), unless otherwise provided by the law, non-investment FIEs shall not make any PE investments within the People's Republic of China with their registered capital in RMB. The FIEs that foreign PE funds established in China as investment vehicles are usually regarded as non-investment FIEs, as they often conduct investment management or consulting services. Due to the said restriction of Circular No. 142, these FIEs face substantive obstacles if they want to carry out PE investment with RMB settled from their registered capital in foreign currency.

Circular No.142 also establishes that FIEs, which are approved by the Ministry of Commerce or its branch offices and primarily engages investment, shall get the approval of SAFE or its branches before transferring their registered capital within China. The Reply of the General Affairs Department of the State Administration of Foreign Exchange on Issues Relating to Equity Investment by Foreign-invested Venture Capital Enterprise upon Settlement of Their Capital in Foreign Currency ("Circular No. 125") also provides that a foreign invested venture capital ("FIVC") may conduct equity investment in China with its capital in foreign currency and such investment shall be within its business scope. To get the approval of SAFE, the FIVC shall perform the approval procedures for an investment project. Moreover, the FIVC shall transfer its registered capital in foreign currency to the investee company, which shall settle the capital in RMB.

Clearly, Circular No.125 targets the FIVCs. At present, it remains unclear what foreign exchange administration rules a foreign invested partnership ("FIP") shall follow. A number of foreign-invested PE funds have been approved and established as FIPs since the implementation of the Administrative Regulation on the Establishment of Partnerships by Foreign Enterprises or Individuals within China and the Administrative Regulation on the Registration of Foreign Invested Partnerships on March 1, 2010. Before the official introduction of QFLP, it is likely that FIPs might be required to settle foreign currency in compliance with the rules for FIVC. This means that PE funds structured as FIVCs or FIPs may engage in PE investment in China, but their investments are subject to foreign exchange approval procedures. As the investees are required to be responsible for foreign exchange settlement when receiving PE investment, PE funds structured as FIVCs or FIPs may be in a precarious position when competing with other types of PE funds on PE investment projects.

According to the Pilot Program, the QFLP might be able to remove the foreign exchange control barriers that PE funds and their GPs may encounter. The QFLP is similar to the Qualified Foreign Institutional Investors ("QFII"), under which the foreign investors meeting certain qualifications may invest in PE funds provided that the dollar amount of their investments do not exceed the limit approved by SAFE. The investments by QFLP may be in foreign currency but the investees shall settle the investments in RMB. However, the total dollar amount that each PE fund (which has QFLPs) settles in RMB shall not exceed USD 100 million or 50% of the total capitalization of the PE fund. The dollar amount of foreign currency that the GP of the PE fund settles shall not be more than 5% of the total capitalization of the PE fund. If the QFLP is implemented, GPs of foreign invested PE funds will no longer face substantive practical barriers when settling their capital from foreign currency to RMB to conduct PE investments in China

II. Eligibility of National Treatment

According to the existing PRC laws and regulations and the interpretation by relevant authorities, a FIVC or FIP established in China is generally treated as foreign investors when conducting investment projects. In essence, their investment projects are required to follow the filing or approval procedures applicable to foreign investment projects. In addition, the domestic company that a FIVC or FIP invests in will be regarded as a FIE. Compared with these procedures, the administrative procedures applied to domestic PE funds are much simpler. Moreover, the investees of Chinese PE funds remain to be treated as domestic companies so that they will face less obstacles if they plan to go public or enter into the reorganization proceeding. This is another disadvantage that FIVCs and FIPs experience when competing on investment projects with domestic PE funds.

It is possible that the Pilot Program is adopting a more lenient approach towards the national treatment for foreign invested PE funds. For example, the Pilot Program might grant national treatment to the PE funds with only one foreign general partner (possibly a FIE). In other words, a PE fund will be regarded as a Chinese PE fund, if one of its GPs is a FIE and the rest of its GPs are domestic entities. However, if any of the limited partners ("LPs") of a PE fund is a FIE, such a PE fund might not be entitled to national treatment under the Pilot Program.

Under the current PRC law, if all partners (LPs and GPs) of a PE fund are domestic entities (including FIEs), they may structure the PE fund as a domestic partnership, instead of a FIP. In practice, a PE fund may adopt a structure that is subject to the discretion of the competent local branch of SAIC and may be applicable only in some areas of China. PE funds structured as domestic partnerships might be deemed as domestic PE funds and entitled to national treatment when making investments, since the relevant authorities cannot legally require them to perform the administrative procedures applicable for foreign investors. However, this will remain a concern for FIEs that overseas PE funds establish in China as investment vehicles, before the legislation approves such national treatment to PE funds and their partners.

Relevant government authorities will be extremely careful when formulating the policies regarding the eligibility of national treatment. Where FIEs are the GPs of a PE fund, the percentage of their capital contribution to the total capitalization of the fund is relatively small. Therefore, these FIEs are less likely to circumvent the Chinese government's industrial restriction on foreign investment, even if such a fund is given national treatment. Conversely, if FIEs are the LPs of a PE fund, the percentage of their capital contribution to the total capitalization of the fund will be large. In this case, these FIEs may by pass the industrial restriction on foreign investment by becoming LPs of a PE fund, (as there is no legal basis to require such PE fund to get approval) if they are granted national treatment. Due to the restriction of foreign exchange settlement established by Circular No. 142, the newly established FIEs face difficulty to obtain sufficient capital in RMB to make capital contribution to PE funds as LPs, unless they have generated RMB income in China. Essentially, QFLP may be only applicable to foreign LPs. In other words, QFLP might not be applicable to LPs that are FIEs to clear the foreign exchange administration barriers FIEs may encounter when they invest in China.

Although the Pilot Program has not yet been officially announced, it has already attracted wide attention and sparked extensive discussion in China's private equity industry. If the Pilot Program launches a major policy breakthrough, it is very likely that we will see another boom of PE funds. In the past, although the relevant authorities in Beijing, Tianjin, and Shanghai introduced a series of policies to support the development of PE funds, these policies were unable to effectively motivate the investors as none of them provided solutions to foreign exchange control and national treatment restriction, two major roadblocks that PE funds involving foreign partners face in China. Upon the launch of the Pilot Program, the Pudong New Area of Shanghai could become a new venue for foreign investors to invest in China-based PE funds.

According to Circular Hui Zong Fa [2008] 142 (“Circular 142”), unless otherwise provided for under law, the capital of a foreign invested enterprise (“FIE”) shall not be used for equity investment. If an FIE intends to act as a GP of a RMB PE fund, it will find it difficult to satisfy the GP’s RMB commitment (often 1% of the total commitment of the fund) because the FIE cannot convert its capital into RMB. This further effectively blocks the means by which an FIE is able to act as an LP because it is much more difficult for it to satisfy the LP’s RMB commitment, which is typically substantially higher than a GP’s commitment.

The Trial Plan is intended to establish a Qualified Foreign Limited Partner (“QFLP”) mechanism by adopting the approach similar to the QFII (Qualified Foreign Institutional Investor) system, and allows foreign funded GPs and LPs to convert foreign exchange capital into RMB. The aggregate quota for foreign exchange convertible into RMB shall not exceed 50% of the size of the fund, and the quota for a GP shall not exceed 5% of the fund size.

It is unclear if foreign funded GPs and LPs refers to foreign investors only or both foreign investors and FIEs, which are Chinese entities partly or wholly owned by foreign investors. Also, as is known by veterans of the Chinese PE industry, a domestic partnership’s partners shall all be Chinese individuals or Chinese entities, which may include FIEs. This allows indirect foreign investment (with difficulties arising from foreign exchange conversion). On the other hand, a foreign invested partnership may directly accommodate a foreign GP or LP. Therefore, either a domestic partnership and a foreign invested partnership both allow the participation of foreign investment. However, it is unclear if the Trial Plan will apply to both domestic partnerships and foreign invested partnerships.

Though not crystal clear, a domestic partnership with indirect foreign investment is likely to be treated equally as other pure domestic funds in terms of portfolio investment, but a foreign invested partnership will be treated as a foreign investor and subject to industrial restrictions and cumbersome approvals. If the Trial Plan does apply to domestic partnerships, that will be a real breakthrough and Pudong will be better positioned to attract RMB PE funds than its competitors in China. Further details will be publicized in April.
 

Prior to the promulgation of the Pilot Measures, the Shanghai Financial Services Office, in conjunction with the Shanghai Administration for Industry and Commerce, State Taxation Bureau of Shanghai Municipality and Local Taxation Bureau of Shanghai Municipality, issued a notice on industrial and commercial registration of equity investment enterprises in Shanghai (Hu Jin Rong Ban Tong [2008] No. 3) ("Notice") on August 11, 2008. The Notice specifies the basic conditions for equity investment management enterprises. But in practice, the examination and approval authorities or the registration authorities generally only apply the provisions regarding equity investment management enterprises in the Notice to domestic enterprises and not foreign enterprises.

I. Mandatory Requirements for Establishment of Foreign-invested Equity Investment Management Enterprises

According to the Pilot Measures, foreign-invested equity investment management enterprises refer to Sino-foreign equity or contractual joint ventures, or wholly-foreign owned enterprises, which are incorporated in Pudong New Area by foreign companies, enterprises, other economic organizations or individuals, and mainly engage in equity investment management upon entrustment of equity investment enterprises.

Meanwhile, the equity holders and senior management personnel of the foreign-invested equity investment management enterprises shall satisfy certain legal requirements, including: (1) a foreign-invested equity investment management enterprises shall have at least one investor (equity holder), and the business scope of the investor or its affiliates shall include equity investment or equity investment management; (2) when applying for incorporation, the foreign-invested equity investment management enterprise shall have more than two senior managers with over two years experience in equity investment or equity investment management and they shall have over two years experience in senior management positions.

According to the Pilot Measures, a foreign-invested equity investment management enterprise shall be incorporated as a limited liability company with a registered capital of USD 2,000,000 or more.
 

An established foreign-invested enterprise that meets the forgoing conditions may apply for conversion into a foreign-invested equity investment management enterprise.

II. Preferential Treatment for Foreign-invested Equity Investment Management Enterprises

The Shanghai Pudong New Area Financial Services Office and Finance Bureau published the Circular on Issuance of Opinions on Promoting Development of Equity Investment Enterprises and Equity Investment Management Enterprises in Pudong New Area ("Opinions") on December 15, 2008, and Implementing Rules on Promoting Development of Equity Investment Enterprises and Equity Investment Management Enterprises in Pudong New Area ( "Implementing Rules") in March 2009. The Opinions and Implementing Rules set forth preferential and supporting policies for equity investment enterprises and equity investment management enterprises. These policies include:

(a) "For an equity investment management enterprise incorporated as a company, its chairman, vice chairman, general manager and deputy general manager shall receive 40% of their respective paid annual income tax as a subsidy, and the core staff acting as investment manager or project manager shall receive 20% of their respective paid annual income tax as a subsidy;
(b) For an equity investment management enterprise incorporated as a company managing a capital of RMB 1,000,000,000 or more, its chairman, vice chairman, general manager and deputy general manager shall each receive housing or lease subsidy of RMB 200,000 in a lump sum.
(c) An equity investment management enterprise, which is entrusted by an equity investment enterprise incorporated as a partnership to conduct equity investment management business, may receive an award in a lump sum based on the funds actually raised by the equity investment enterprise in the current year: an award of RMB5 million where RMB1 billion is raised; an award of RMB10 million where RMB3 billion is raised, or an award of RMB15 million where RMB5 billion is raised. The amount of the award shall be increased for enterprises which provide substantial contribution to the development of Pudong financial industry."

III. Approval Authority and Procedures for Establishment of Foreign-invested Equity Investment Management Enterprises

The establishment of foreign-invested equity investment management enterprises, either by incorporation or conversion, requires the approval from Shanghai Pudong New Area Economic Commission (the "Pudong Economic Commission"). According to Pudong Economic Commission, the preparation of documents and approval procedure for the application for establishment of foreign-invested equity investment management enterprises is similar to that required for establishment of general foreign-invested enterprises.

Upon accepting the application, Pudong Economic Commission will also consult with Pudong Finance Office regarding the application materials. Pudong Finance Office will then examine and appraise the qualification of the equity holders and senior management personnel of the foreign-invested equity investment management enterprises. Before approving an application, Pudong Economic Commission will verify whether the said equity holders and senior management personnel are qualified according to the Pilot Measures.

The promulgation of the Pilot Measures has given the green light for incorporation of equity investment management companies by foreign equity investment entities in Pudong New Area. However, the Pilot Measures, which have not established detailed rules for their implementation, need to be refined by relevant authorities in the future.