On December 31, 2019, the State Council of China published the Implementing Regulation for the Foreign Investment Law of the PRC (the “FIL Implementing Regulation”). The FIL Implementing Regulation, together with the Foreign Investment Law (the “FIL”), came into force the very next day – January 1, 2020 – heralding a new era of foreign investment regime in China. The key word for the new regime is “national treatment”, replacing “governmental approvals”. The foreign investment vocabulary will also receive an overhaul, concepts such as “Sino-foreign joint venture”, “total investment” and “joint venture contract”, which were specifically used for Sino-foreign joint ventures, will phase out.
It took the Ministry of Justice (MOJ), the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC) 9 months to draft the FIL Implementing Regulation after the promulgation of the FIL on March 15, 2019. A draft FIL Implementing Regulation was released back in November 2019 to solicit public comment, the final version has incorporated substantial changes in an effort to reflect public comment received – this is certainly something that rarely happened in past legalisation processes. This long-awaited regulation introduces a new regulatory regime, setting out detailed rules on certain issues touched on by the broad strokes of the FIL. On the other hand, it remains silent on a number of sensitive topics closely watched by the business community. This demonstrates the Chinese government’s commitment to improve overall environment for foreign investment while remaining prudent when facing complicated issues regarding foreign investment regulation, all against the bigger picture of the ever-changing landscape of international relations.
Highlights of the FIL Implementing Regulation
Adopting the same structure of the FIL, the FIL Implementing Regulation has 49 articles, 4 more than the draft regulation, including a new chapter dedicated to legal liabilities for non-compliances. Some of the most notable highlights of the FIL Implementing Regulation are:
(a) Enhanced Enforceability of Investment Agreement with the Government
Almost all foreign investors are bound to work closely with different levels of Chinese government, in particular for greenfield projects. Foreign investors frequently enter into investment agreements with local governments to secure preferential treatments and incentives, such as access to land and facilities, tax benefits, etc. While not a common occurrence, there are times when foreign investors find it difficult to enforce these agreements if the government tries to back out of its commitment for reasons like change of head of local government, reshuffling of the functions of governing body, or the original agreement being no longer deemed in line with its ever-evolving agenda. Very few, if any, foreign investors ultimately resort to legal proceeding for fear of jeopardizing their relationship with the government. Even if foreign investors choose to take legal action, they may find it hard to achieve their goal due to the lack of legal basis for regulating and enforcing such investment agreements.
Within the context described above, the FIL explicitly sets out the principle that “local governments at all levels shall fulfil the policy commitments made to foreign investors and foreign-invested enterprises (“FIEs”) and all types of contracts executed pursuant to the law.” In the same vein, Article 27 of the FIL Implementing Regulation defines “policy commitments” as commitments made by local governments at all levels to provide preferential treatments and other support to attract foreign investment within their legal authority. Taking a step further, Article 28 provides foreign investors with more comfort in that government authorities shall not unilaterally alter policy commitments or contractual agreements unless national interest and public interest are at stake, nor shall they violate or breach any contract on the ground of administrative area adjustment, re-election, organizational or functional adjustments or change of head of governing body; fair and reasonable compensation shall be provided to investors in case of any unilateral changes to such agreements for the purpose of state or public interest.
On December 10, 2019, the Supreme People’s Court addressed the same issue in a judicial interpretation, which aims to boost the credibility of the government by ensuring local government’s fulfilment of their policy commitments and other undertakings made to investors. The 10 cases published by the Supreme Court provides better ground for investors to seek enforcement of investment agreements entered into with the government. However, both the FIL Implementing Regulation and the judicial interpretation stop short of providing guidance as to when commitments are made to investors “according to law” or what rights are “within their legal authority”. The legality of governmental commitments or governmental agreements still need to be closely reviewed in practice. Investors should be reminded to pay more attention to the issue of legitimacy when negotiating an investment agreement with the government.
(b) New Regulatory Regime for Foreign Investment
It is no exaggeration to say that the FIL Implementing Regulation will significantly change the regulatory landscape for foreign investment. Taking the establishment of an FIE for example, the old regulatory regime used to involve four different lines of regulators as shown in the following table:
|Investment Project||NDRC and its local counterparts||Approve or maintain record filing of foreign investment projects|
|Foreign Investment Approval||MOFCOM and its local counterparts||Based on the Special Administrative Measures (Negative List) for the Access of Foreign Investment (Negative List), approve or maintain record filing of the establishment and subsequent changes of FIEs|
|Operational License||Sector Regulators in charge of the specific industries involved||According to the specific requirements of the relevant industry, decide whether to issue necessary industry-specific licenses|
|Company Registration||State Administration for Market Regulation (SAMR) and its local counterparts||Process registration of establishment and subsequent changes of FIEs|
Note: Foreign investment national security review is required for proposed foreign investments that may raise national security concerns; where a proposed foreign investment amounts to concentration of undertakings, it is subject to anti-competition review.
In recent years, Chinese regulators have replaced the original “case-by-case approval approach” with the Negative List approach”, in an effort to simplify the establishment and registration process for FIEs. Nevertheless, it may still be confusing to foreign investors when it comes to which government authority is in charge of what and what happens when there is overlapping or even contradictions. For example, both NDRC and MOFCOM assert jurisdiction over foreign investment entry, and in some cases there is disconnection between industrial regulations and foreign investment regulations. The FIL Implementing Regulation makes it clear that NDRC will retain its function to approve / maintain record filing of foreign investment projects, while industry authorities will retain their power to issue industry specific licenses. SAMR is responsible for the registration of foreign invested enterprises.
However, the new regime has taken away the power of MOFCOM to review the establishment of foreign investment entities. As such, MOFCOM – the long-time watchdog for foreign investment – will only take the back seat in monitoring foreign investment through its information reporting system. This means no approval or record filing will be required from MOFCOM for incorporation of an FIE, neither joint venture contracts will be subject to its review or approval. Many investors have the experience of negotiating with their Chinese partners and often hearing excuses that certain commercial arrangements (such as put/call option) would not be accepted by MOFCOM. This will become history with the introduction of the new regulation regime.
In addition, Article 35 of the FIL Implementing Regulation provides that in case any FIEs apply for any industry specific licenses, the relevant authorities shall apply the criteria and procedures that are applicable to domestic entities. The above provisions aim to level the playing field for investors both domestic and abroad, will this mean foreign investment will receive national treatment in real life after its entry into China market? In practice, a number of industry specific rules and regulations impose various restrictions on foreign investment. These restrictions are often broader than those enumerated in the Negative List, including special requirements applicable to foreign investors in shareholder qualification, industry experience, and registered capital. Article 35 of the FIL Implementing Regulation only recognizes that laws and administrative regulations (issued by People’s Congress and State Council, respectively) may set out special requirements for FIEs, that would mean the industry specific regulations and departmental rules issued by the various ministries will become obsolete. If this approach is eventually adopted, the FIL Implementing Regulation will undoubtedly lay the groundwork for achieving the ultimate goal of national treatment for foreign investors.
(c) VIE Structure
The market has been eagerly waiting to see how the FIL Implementing Regulation will address the legality of VIEs (variable interest entities). As a matter of fact, VIEs has allowed Chinese companies in certain restricted industries (such as internet, e-commerce, education, etc.) to obtain foreign financing for their growth. However, the legality of VIEs has never been fully recognized. Regulators and market players have very different attitudes towards VIEs. While the market expects VIEs to come out of its “grey area” and become fully legalized, regulators have been trying to eliminate loopholes that allows the existence of VIEs. The 2015 Draft Foreign Investment Law (“2015 Draft FIL”) drafted by MOFCOM attempted to address the VIE issue by adopting the “de facto control” doctrine, but was instantly faced with hot debate and caused quite a stir in the capital market. HKEX, the stock exchange where many companies adopt VIEs are listed, even produced corresponding guidelines before the 2015 Draft FIL becomes law, which it never did.
FIL and the FIL Implementing Regulation made a conscious choice by remaining silent on the topic. Considering the large number of enterprises currently taking advantage of the VIE structure, the potential repercussion if the status quo is broken could be more than significant. The FIL Implementing Regulation’s silence is widely expected. In fact, it is exceedingly hard to find a perfect resolution acceptable to all stakeholders. Maintaining the status quo is apparently the most pragmatic approach for the time being.
Notably, Article 2 of the FIL provides that “foreign investment” includes the circumstance where a foreign investor acquires shares, equities, property shares or any other “similar rights and interests” of an enterprise within the territory of China. Such “similar rights” is a term broad enough to include interests derived from VIEs. It not only affords companies enough room to manoeuvre but also gives the government ground to asset jurisdiction over VIEs, when the time is right. Against the background of the continuous reform and opening up of China and decrease of foreign investment restrictions (for example, the total number of items in the 2019 edition of the Negative List has been slimmed down to 40), we expect the government may deal with VIEs in the future when such issue is ripe for resolution.
Another popular topic relating to VIEs is round-trip investment by Chinese investors, which is associated with red chip model when Chinese companies are listed offshore. The draft FIL Implementing Regulation attempted to introduce a carve-out that, upon approval of the State Council, a company wholly owned by a Chinese investor making round-trip investment through an offshore entity may be exempted from restrictions for foreign investment listed in the Negative List. However, this did not make into the FIL Implementing Regulation due to controversies in how to regulate the round-trip investment as well as difficulties in exercising ongoing supervision in practice.
(d) Protection of Intellectual Property Rights
Article 23 of the FIL Implementing Regulation calls for harsher punishment for intellectual property infringement, but it deleted the original wording for punitive damages as proposed in the draft FIL Implementing Regulation. Nonetheless, the concept of punitive damage has been introduced in the recently amended Trademark Law, so are the draft Civil Code and draft amendment to the Patent Law of the PRC. It can be expected that the introduction of punitive damage will provide more ammos to improve intellectual property protection in China.
With respect to forced technology transfer – an issue for which China has been widely criticized by western community – Article 24 of the FIL Implementing Regulation provides direct and clear guidance: administrative authorities shall not, directly or indirectly, force foreign investors or FIEs to transfer technologies in any administrative procedures; Article 43 further provides for penalties upon persons in charge for violation of this rule. These clauses aim to eliminate improper governmental interference in technology transfers. Earlier in 2019, the State Council amended the Regulation on the Administration of the Import and Export of Technology and deleted a number of restrictive provisions on technology import contract, such as the ownership of technology improvement, which is often an issue of controversy in negotiation of technology license agreement. This is another attempt from the Chinese government to address concerns of foreign investors by stressing the principle of free will and fairness in technology transfer.
(e) Foreign Investment Information Reporting System
At the moment, FIEs submit information through two channels: (i) the MOFCOM foreign investment information system and (ii) the SAMR company registration system and enterprise credit information disclosure database. The FIL proposes a unified foreign investment information reporting system combining said two channels in order to lower the reporting burden on FIEs. The scope and content of information required to be submitted by FIEs are limited to those deemed necessary by law and regulations. Articles 38 and 39 of the FIL Implementing Regulation reiterate the forgoing principle and grant MOFCOM and SAMR the authority to draft specific rules for foreign investment information reporting.
On December 31, 2019, MOFCOM and SAMR jointly issued the Measures for the Foreign Investment Information Reporting. Under such measures, FIEs are required to submit information such as the initial report, change report, dissolution report and annual report, but are explicitly exempted from separate submission of information which can be obtained via information sharing between different governmental bodies, such as information regarding deregistration and domestic investment (including multi-layer investment). On the same day, MOFCOM issued Notice on Matters Related to Foreign Investment Information Reporting, providing detailed practice guide and specific content of information reports. Information already submitted to SAMR by FIEs will be shared with MOFCOM and does not need to be separately submitted again by FIEs or foreign investors in information reports. Furthermore, annual report will take the approach of “integrating multiple reports into one” – meaning FIEs simply need to add specific information required by MOFCOM and the State Administration of Foreign Exchange (SAFE) to the annual report already being prepared for SAMR. This will avoid repetitive submission of the same information and effectively reduce the reporting burden on FIEs and foreign investors.
(f) Five-year Transitional Period and Survival of Existing Arrangements
The FIL came into effect on January 1, 2020 and replaced the Laws on Sino-foreign Equity Joint Ventures, Sino-foreign Co-operative Enterprises and Wholly Foreign-owned Enterprises (hereinafter as “Former FIE Laws”). The Former FIE Laws provides for corporate governance rules for FIEs which are different from those set out under the Company Law. For example, a Sino-foreign joint venture does not have shareholders meeting, and its board of directors is the highest governing body. FIL allows corporate governance structure of existing FIEs to continue for a five-year transitional period, but changes need to be made to comply with FIL by January 1, 2025.
What’s on the mind of every existing FIE is the question of what happens if it somehow fails to adapt before the transitional period expires (such as the parties of a joint venture cannot reach agreement in time). Article 44 of the FIL Implementing Regulation provides that if adaptation is not completed within the transitional period, SAMR will not process other registration matters for such company, and may disclose such incompliance in the credit information disclosure database. The penalty provided under Article 44 is both mild and pragmatic as it would not jeopardize the existence and operation of existing FIEs. But it still leaves many related questions unanswered, such as whether the original joint venture contracts and articles of association will remain valid, and whether decisions made by governing bodies of the FIEs will be valid, which will need to be tested in practice.
In addition, Article 46 of the FIL Implementing Regulation provides that some arrangements between shareholders such as distribution of profit and remaining assets amongst shareholders of FIEs will continue to be valid after the necessary changes for the governance structure have been made. This means the shareholders of existing FIEs may continue to take advantage of the more flexible arrangements with respect to distribution of profit and remaining assets afforded under the Former FIE Laws for the remaining term of the FIEs.
New Foreign Investment Regime: A Promising but Challenging Future
The FIL Implementing Regulation’s most imminent mission is to provide implementing guidance for the FIL and facilitate transition into the new foreign investment regime. Given the complexity of the existing foreign investment regime and ancillary rules created in the past 40 years, the transition is not going to be easy. Questions which are left unanswered by the FIL Implementing Regulation need to be further clarified and solved by the authorities step by step. In addition to the VIE structure and transitional period discussed above, there are a number of issues that need to be resolved. We have identified what we think are the most significant issues below.
(a) Reinvestments by FIEs
Article 2 of the FIL stipulates that the term “foreign investment” refers to any directly or indirect investment made by any foreign investor. As such, any reinvestment made by an existing FIE in China should be captured by the FIL as well. Currently, the practice in different industries in this respect varies greatly. For example, SAMR designates direct subsidiary of a foreign-invested enterprise as “invested by FIEs”, but any subsidiaries from that level downward are treated the same as domestic companies. To the contrary, regulation of value-added telecom industry by the Ministry of Industry and Information Technology seeks to trace back to the ultimate shareholder when determining whether a company is foreign-invested. The FIL Implementing Regulation does not establish universal and detailed rules to regulate such reinvestment by FIEs, for example, how the Negative List should apply to such reinvestments. Regulators will have to come up with clearer guidelines about how reinvestment by FIEs will be treated.
(b) Governing Law for Joint Venture Contracts / Shareholders Agreements
According to the relevant provisions of the Former FIE Laws, any joint venture agreements and cooperation agreements are mandatorily governed by PRC law. The same provisions can also be found in the Contract Law. As the Former FIE Laws and their implementing rules have been abolished, will the joint venture contracts / shareholders agreement entered into between the Chinese and foreign shareholders continue to be governed by PRC law? Will the parties be free to choose the governing law of their agreements? Given that the provisions of the Contract Law are still valid and the FIEs are incorporated in China, it is likely that these agreements will continue to be governed by PRC law in particular if relate to corporate governance issues.
(c) National Security Review
Contrary to the 2015 Draft FIL, which dedicated an entire chapter to national security review, the FIL mentions the principle of national security review only once. Likewise, the FIL Implementing Regulation does not elaborate on this topic – Article 40 reiterates the principle that the Chinese government will establish national security review of foreign investment, leaving out the details. At present, a notice issued by the State Council and one rule issued by MOFCOM are the only regulations dedicated to national security review, and both of which are relatively brief and only applicable to mergers and acquisitions of domestic companies by foreign investors. Given that protectionism is gaining momentum around the world and a number of major western countries are tightening scrutiny on foreign investment, it is likely that the Chinese government may also create separate legislation on foreign investment national security review to better protect its very own national interest.
(d) Housekeeping of Existing Foreign Investment Regulations and Rules
On the basis of the Former FIE Laws and their implementing rules, MOFCOM, NDRC, SAMR, SAFE, and financial and tax authorities have formulated a large number of ancillary regulations and rules in the past 40 years. With the abolition of the Former FIE Laws, a large number of regulations and rules also need to be abolished or amended. Article 49 of the FIL Implementing Regulation provides that the FIL and the FIL Implementing Regulation shall prevail in case of any discrepancy (related to foreign investment regulation) between them and any other regulations or rules promulgated prior to January 1, 2020. While said provision establishes the principle for resolving potential discrepancies, there may still be problems in practice without proper housekeeping of existing foreign investment regulations and rules. At the moment, relevant authorities such as MOFCOM, NDRC and the MOJ are all in the process of cleaning up existing regulations and rules. Just within the last week of 2019, the Supreme Court, MOFCOM and SAMR have issued FIL-related judicial interpretations or ancillary rules. MOFCOM, in particular, has issued two notices regarding the clean-up of existing rules, but a large number of ancillary regulations and rules still remain to be dealt with. We expect the housekeeping of the implementing rules of the Former FIE Laws and other ancillary regulations and rules will be completed and disclosed to the public very soon. It is also our expectation that the relevant authorities will provide clarifications and explanations to issues arising from the implementation of the FIL to ensure a smooth transition into the new foreign investment regulation regime.
The Negative List is issued and updated periodically by NDRC and MOFCOM.
 Foreign investments are reviewed and approved on a case-by-case manner.
 Foreign investments in sectors listed on the Negative List will be reviewed and approved on a case-by-case manner, while investments in all other sectors only require record filing.
 Notice of the General Office of the State Council on the Establishment of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors.
 Provisions of the Ministry of Commerce on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors.