The recently passed Foreign Investment Law marks China’s new regulatory framework for foreign investors. We consult some experts for their informed analysis

The National People’s Congress passed the Foreign Investment Law (FIL) on 15 March 2019, sparking the kind of interest around the world reserved for major market initiatives. The potential of this new law has not been lost on any investors, particularly those who until now have avoided China’s market for its lack of transparency and perceived bias.

The FIL replaces three old laws on foreign investment (the Law on Sino-Foreign Equity Joint Ventures, the Law on Sino-Foreign Co-operative Joint Ventures and the Law on Wholly Foreign-owned Enterprises).

Marking a unified regulatory regime for governing foreign capital coming to China, the new law is widely seen as a landmark of China further opening its market and providing stronger protection to foreigners.

We asked some legal experts about key implications of the new law and sought clarification on aspects of the law that have not as yet been sufficiently refined. The following are their observations.

Eric-Liu

China Business Law Journal (CBLJ): Compared with the previous three laws on foreign investment, what are the significant new aspects of the Foreign Investment Law?

Fan Jiannian, partner, Gide Loyrette Nouel in Shanghai: One of the main highlights of the FIL is the principle of consistency between domestic and foreign investment. You may find “equal treatment” is repeated throughout the FIL to ensure that domestic investment and foreign investment are subject to a unified set of rules. For example, article 9 provides that foreign invested enterprises (FIEs) are equally qualified for state policies that support enterprises; article 15 grants FIEs the right to equal access to the formulation of industry standards; and article 16 states that FIEs may fairly participate in government procurement projects.

In terms of corporate governance, the FIL will also cancel the specific rules only applicable to FIEs, but apply the general rules fixed by the Company Law, Partnership Law etc., to all enterprises, no matter whether they are foreign invested or domestic invested.

Eric Liu, managing partner, Zhao Sheng Law Firm in Shanghai: From a policy perspective, the central government has been keen to encourage more foreign investment. With the new law enacted, we believe that it is a good time for foreign investors to consider investment opportunities in China.

The new FIL will replace the three older statutes that govern foreign-invested entities and serve as the “unified law” for foreign investments in China. This milestone also sets the tone for foreign investments in China going forward, i.e., FIEs will be entitled to the same treatment as domestic companies.

The three older statutes have been revised several times to accommodate the opening-up process. Foreign investors have witnessed the relaxation of regulator controls (in particular, over market access in various industries and foreign exchange controls). FIEs will be able to enjoy “national treatment” under the umbrella of the new foreign investment regime, which will provide FIEs with a level playing field to compete with [domestic] competitors.

The proposed changes go some way to address criticism from foreign governments, as well as the long-term expectations of foreign investors. These will definitely be welcomed by foreign market participants and lead the next upsurge in foreign investment, especially in the technology, media, telecom (TMT), automotive and financial sectors.

CBLJ: How can the new law benefit foreign investors with regard to market opportunities, regulatory treatment and protection of their interest?

Fan Jiannian: For market opportunities, the FIL explicitly confirms that foreign investment is subject to the “pre-market access national treatment plus negative list system”. The negative list, which determines market access for foreign investors, was started in 2013 in the China (Shanghai) Pilot Free Trade Zone, and expanded nationwide in 2018, but this is the first time the “national treatment plus negative list system” has been written into a basic law.

Fan-Jiannian

Foreign investors and their investments will be entitled to treatment not less favourable than domestic investors and their investments. This national treatment principle will apply to all foreign investments not included on the negative list. On top of that, foreign investment will be subject to an information reporting system and national security review system.

The FIL does emphasize the facilitation and protection of foreign investment. For example, in the field of intellectual property (IP) protection, the FIL expressly stipulates protections for IP rights held by foreign investors and FIEs, and encourages technology co-operation based on the principles of voluntariness and commercial norms, and forced technology transfer is prohibited.

Other protections include prohibition of expropriating foreign investments unless in special circumstances. Local governments are required to comply with commitments that they lawfully made to foreign investors and the contracts they have entered into. In addition, a complaint mechanism for FIEs is also established to address issues encountered by FIEs or their investors.

CBLJ: What uncertainties in the FIL need to be resolved? How might such uncertainties affect foreign investment?

Fan Jiannian: There are quite a few uncertainties in the FIL. For example, the definition of “foreign investment” in the FIL includes an investment category of “new project” by foreign investors. However, it does not specify what constitutes a new project.

Another uncertainty is the FIL continues to place variable interest entities (VIEs) in a legal grey area. The 2015 draft of the FIL subjected VIEs to the foreign investment regulatory regime and caused much controversy. It remains to be seen how the regulatory position on VIEs will evolve, whether they will be caught by the catch-all clause of the definition of foreign investment, or be considered indirect investment by foreign investors under the FIL.

In addition, the FIL grants a five-year transition period from its effective date, during which existing FIEs may maintain their current organizational forms. However, it is unclear whether they must complete the changes required to comply with the Company Law within this transition period, or whether they will be forced to do so if they fail to implement the changes.

Will cancelling the three laws of foreign investment also change the mandatory requirement of choice of Chinese law as applicable law for certain specific contracts such as the Sino-foreign joint venture contract? Or will such requirements still be kept in the Contract Law as an exception? These aspects remain to be further clarified by government authorities.

CBLJ: The new FIL has formally prohibited forced technology transfers and assured IP protection. In the meantime, IP-related provisions of the Technology Import and Export Administrative Regulations (TIER) and the Sino-Foreign Equity Joint Venture Law Implementing Regulations (EJV implementing regulations) were repealed with immediate effect. Foreign investors often saw those provisions as a barrier to bringing their IP into China. How much impact can these IP-related changes have on foreign investors who have already invested in China? How likely is it that they will change business arrangements or structures they have already set up?

Andrew-McGinty

Andrew McGinty, partner, Hogan Lovells in Shanghai: Since neither the amendments to existing legislation (the TIER and the EJV implementing regulations) nor the adoption of the new FIL have any retroactive effect, then technically there is no hard legal obligation to immediately change any business arrangements or structures set up or agreed on before.

However, you need to draw a distinction here between the TIER and the EJV implementing regulations on the one hand, and the FIL on the other. The former were amended with immediate effect on 18 March, so are already in force. The FIL, on the other hand, only takes effect on 1 January 2020, but provides that foreign investors under current structures have five years to change over to new governance structures based on the Company Law or the Partnership Law, but will probably want to move over more quickly as soon as the meat in the sandwich – i.e., the implementing rules that will govern vehicles established under the FIL – are issued.

It is unclear at the time of writing to what extent, for example, the existing rules on debt-equity ratios, which have been in place in relation to foreign-invested enterprises since 1987, will continue to apply under the FIL, which is completely silent on the topic. Those setting up joint ventures from now until 1 January 2020 in particular (as these will be the most impacted under the FIL) may wish to put in place a “flip-over” structure, whereby they agree to a set of documents under current law but also agree to a set of documents that are pre-adopted by the parties but which take effect on 1 January 2020, to avoid having to open up a new negotiation within less than a year.

For those foreign investors with existing equity joint ventures (EJVs) in China involving technology licensing or foreign licensors licensing into China, if they have a strong bargaining position (e.g., because of the sheer volume of business they bring to their Chinese partner, or because of the dependence of the Chinese partner on the foreign IP), there may be room for renegotiation of some of the business arrangements already in place.

It is likely that the two most thorny IP issues (ownership of improvements, and IP indemnity) will be the first to be addressed in such attempts – for example, foreign investors have long found it difficult to accept that a Chinese licensee, whether its own EJV or an independent third party, should have a right to make improvements – which the owner of the technology may not want or recognize as such.

Absent such strong bargaining position, this author does not think it is likely that foreign technology licensors will find it easy to renegotiate closed deals, unless they are prepared to overhaul the whole arrangement (e.g., royalty discounts and so forth) as there is no corresponding benefit to the Chinese party due to the fact that these changes were made in response to trade pressures, from the EU and US in particular.

CBLJ: Rather than general description, can you analyze a specific case or example to explain how these IP-related changes might assist foreign investors investing in China?

Andrew McGinty: Let us take the hypothetical case of a mining equipment company that wishes to license its newest mining equipment patents to a Chinese partner. Before 18 March 2019, the licensor would have had to guarantee that its patents licensed to the Chinese company did not infringe on any third party IP rights in China. This would normally require a complex “freedom to operate” legal analysis to be carried out, which is very hard in
China given the enormous number of invention patents and the low threshold for utility model patents to be granted. After 18 March 2019, such IP indemnity protecting the Chinese party from any third party IP infringement claims is no longer required, but may still be negotiated at the request of the Chinese party.

Another essential novelty is that the foreign licensor can now stipulate that if the Chinese partner makes technical improvements to the patented invention (e.g., a quicker way of sorting iron ore, a technical tweak that makes the sensors of the machinery more receptive), the foreign licensor can stipulate that these improvements will have to be disclosed to it, and that it will own, and have the rights to all patents filed for such improvements.

However, the changes to the TIER are not a free pass. Because of the technology transfer provisions included in the Contract Law, as interpreted by the Supreme People’s Court (SPC), the foreign licensor will have to provide some consideration (e.g., a reduction of the royalty fees) to the Chinese licensee for the transfer of such improvements, to avoid a challenge for invalidity based on the contract being deemed to be a technology monopolization contract.

The foreign licensor may now also include a number of other clauses, e.g., that it must provide a minimum amount of maintenance sessions per year (at a reasonable cost), that the Chinese partner must buy all spare parts rather than those that are essential for the operation of the technology from it (at a reasonable cost), and that the Chinese partner only gets a licence to manufacture and sell the patented mining equipment in mainland China, or mainland China and Hong Kong; following the changes to the TIER and so forth, there are no longer any restrictions on the licensor imposing limitations on the export markets for products made using the imported technology.

Nevertheless, it needs to be stressed that each case needs to be assessed separately, since there are provisions in other laws (such as the Anti-Monopoly Law and the Contract Law, as interpreted by the SPC) that have not been repealed and that can lead to the invalidity of the above clauses.

For example, if the foreign licensor is the only provider of iron ore mining equipment, and therefore has a dominant position on the iron ore mining equipment market, then some of the provisions above could potentially be seen as abuses of a dominant market position, or if the licensor wants to get all improvements without consideration, that could constitute a technology monopolization contract.

In an EJV context, the foreign investor will be able to include an express clause in the EJV contract or the technology licensing contract that the licensee has no right to continue using the technology after the expiry of the contract, and provide an indemnification against breach of this provision.

In short, the restrictions under the TIER and the EJV implementing regulations were designed to protect Chinese licensees, were not market-driven and anachronistic given how far and how fast Chinese companies have moved on in terms of sophistication, and made negotiating these deals a bit like trying to play basketball with one hand tied behind your back.

They certainly put a lot of foreign investors off deploying their IP into China, or led to the adoption of rather convoluted and not necessarily tax-efficient structures where IP from a foreign investor was first licensed to its wholly foreign-owned enterprise (WFOE) in China (which would mean all the then restrictions on technology imports under TIER would apply as between a foreign licensor and a WFOE) and then the WFOE would sub-license on to the final licensee, with only restrictions under domestic law.

Grace-Tso

CBLJ: What was discussed about how to deal with VIE structures during the drafting of the FIL? What is the approach of the final version towards VIE structures?

Grace Tso, partner, Baker McKenzie in Hong Kong: As early as January 2015, the Ministry of Commerce had published the Foreign Investment Law (Draft for Comment) for public review (draft 2015). In draft 2015, the words “actual control” appear several times and the structure “controlling any domestic enterprise or holding interests in any domestic enterprise by contract, trust or other means” was regarded as one form of “foreign investment” that seemed to expressly ban the circumvention of legal restrictions via the VIE structure. Meanwhile, the Illustration of the Foreign Investment Law (Draft for Comment), published in company with draft 2015, did not clarify its position on how to deal with existing VIE structures but offered three possible solutions, which included a reporting system, reporting and recognizing system, and licensing system.

First, where a foreign-invested enterprise that implements contractual control declares to the competent authority of foreign investment under the State Council its actual control by Chinese investors, it may continue to retain the structure of protocol control and the relevant subjects may continue to carry out operating activities.

Second, a foreign-invested enterprise that implements contractual control should apply to the competent authority of foreign investment under the State Council to determine its actual control by Chinese investors. After the competent authority determines its actual control by Chinese investors, it may continue to retain the structure of protocol control and the relevant subjects may continue to carry out operating activities.

Third, a foreign-invested enterprise that implements protocol control should apply to the competent authority of foreign investment under the State Council for access permission and the competent authority of foreign investment under the State Council in concert with the relevant departments will make a decision after considering the actual controller of the foreign-invested enterprise and other factors.

However, the FIL is silent on “actual control”, so it remains to be observed whether any detailed rule for implementation will provide any regulation on this regard.

CBLJ: After it becomes effective, how is the FIL likely to impact those foreign investors that have already used VIE structures to invest in China? What may be the implications for foreign investors who are considering investment through VIE structures?

Grace Tso: Recently, and in the near future, restrictions on foreign investment in many industries will be cancelled by writing off those industries from the Negative List, so the needs for structuring VIEs to circumvent legal barriers will decrease. As a result, there should be no question regarding the legality of VIEs in unrestricted industries. If any implementation rule still adopts the wording of “actual control”, then government authorities may adopt the above-mentioned three possible solutions to deal with existing VIE structures or just maintain all existing VIE structures without adopting the wording of “actual control”.

CBLJ: How likely are Chinese regulators to issue new rules about VIE structures? If so, what might be China’s regulatory approach towards VIEs in future?

Bao Zhi, partner, Baker McKenzie FenXun (FTZ) joint operation in Shanghai: Article 2 of the FIL stipulates that, “This Law shall be applicable to the foreign investment within the territory of the People’s Republic of China”, and paragraph 4 of article 2 further provides that “a foreign investor makes investment in any other way stipulated by laws, administrative regulations or provisions of the State Council”. With those provisions considered, the author understands that the FIL explicitly does not exclude the possibility of defining “contractual control” as foreign investment.

Bao-Zhi

The authors noted that when the bill of the FIL was tabled, the National People’s Congress explained in a statement that by formulating and implementing the FIL, China aims to: firmly carry out high-level investment liberalization and facilitation policies; protect foreign investors’ legal rights and interests; create an international business environment supported by legalization and facilitation, with a high-level opening-up, to boost the economy into high-quality development and fully demonstrate China’s determination and belief to further the expansion of opening-up and promote foreign investment in a positive way.

In view of this, it is reasonable to speculate that the current legislation regarding foreign investment is focusing on further expansion of opening-up and clarifying the governing system over pre-establishment national treatment for foreign investment plus Negative List, and solving the fundamental but urgent problems about how to create a fair market for domestic and foreign investors, and, hence, putting aside controversial and slow-burning problems such as legality of a VIE, which can be solved by delegated legislation or formulation of regulations.