The new Foreign Investment Law and its implementation regulations lay out a blueprint full of promise for international companies in China. But the lack of details may present problems, writes Edward Chin
In one of the most important legislative changes in nearly three decades, the central government has finally moved closer to opening its markets to international businesses through the implementation of the Foreign Investment Law (FIL) and the issue of its Implementing Regulations of the Foreign Investment Law.
Not only is this a change in law, it represents “a change in mindset and a move away from [the] focus on protecting the weaker local businesses to treating all businesses equally,” says Andrew McGinty, a partner at Hogan Lovells based in Hong Kong. It’s a mindset that says to the global business community that China is open for business.
Notes Fang Jian, a partner at Fangda Partners based in Shanghai: “[The law is] a general relaxation in foreign investment, including in the Chinese market, and lays the foundation for further opening up [of] policies and measures.
“[The FIL] has laid down a new framework for China to regulate foreign investment, and has made positive changes to the basic legal system established by the law of foreign-funded enterprises, which means more certainty and freedom of contract for foreign investors to invest in China.”
Some of these changes include: the shift in governance from a board-driven model to a shareholder model; relaxation of the sector-specific foreign investment rules; and the consolidation of the rules governing mergers and acquisitions (M&A) and indirect investment under a single law and regulatory framework.
But although the FIL is a big step in harmonizing the foreign investment regime with the domestic company regime, there remain many challenges and obstacles the law that still need to be addressed for foreign investors interested in China.
Experts are questioning the detail, or the lack of it, in the law and the implementing regulations, in areas that will undoubtedly concern foreign investors. They point to the need for further clarification, which is expected in further amendments, but in the meantime much is open to interpretation, and foreign investors should proceed with caution.
Past and present
“Since the adoption of China’s Equity Joint Venture Law in 1979, and the Co-operative Joint Venture Law in 1998, China has maintained separate rules and processes for creating and governing foreign- and domestic-invested entities,” says Daniel Roules, a partner at Squire Patton Boggs in Shanghai. “Those separate systems have not always yielded equal treatment under the law.”
The previous regime was protectionist and only benefited local business, whereas the new law promotes co-operation and foreign investment. “This law points to a further opening up and radicalization of the system by the government,” says Fang, adding that the government will be cautious and closely monitor the implementation of the law. “Looking at history and practice, the PRC is receptive to new forms of foreign investment unless it is a disadvantage to the Chinese economy.”
Joint venture corporate governance and control. While the FIL may not have a major impact on wholly foreign-owned enterprises, it could be a game changer for joint venture (JV) companies as it moves from a board-driven governance model to shareholder-driven one.
Under the earlier regime, companies needed unanimous board resolutions on important decisions, such as changes to the articles of association, M&A, dissolution of equitable capital and dissolving the company, and foreign companies with domestic JV partners were often at the mercy of their local partners, who could scuttle plans with one dissenting vote in the board. In the new shareholder-driven system, the important decisions can now be taken with a two-thirds majority of support from the shareholders.
“This means that suddenly you have the concept of absolute control, [with just] two-thirds of the shareholding,” says McGinty. “Previously, a partner could, with as little as a 1% shareholding and a member of the board, block resolutions. This can open up interesting opportunities for businesses.”
Now, with the idea of absolute control, former joint venture partners will be keen on creating structure where they can ensure that they keep control. For example, a JV with a 70/30 partnership has the majority shareholder with absolute control, so the minority partner is now at a disadvantage and may want to demand more. Or in the case of equal JVs, one of the partners may see this as an opportunity to buy more of a stake and thereby gain absolute control of the business, and this could be contentious.
For JVs that already exist, “The government has given a five-year window for companies to shift to this new form of governance, and at the end of the period, companies will be forced to shift,” says McGinty. “If they don’t, the government will stop giving approvals. A lot of the companies will want to kick the can down the road, but we have been advising our clients to deal with [it] earlier,” he says. Although five years is plenty of time, the negotiation process will take time, and the sooner one starts these negotiations, the higher the likelihood that a deal will be struck, benefiting both parties.
The negative list. Another major change in the FIL is the shortening of the negative list, which is a list of sectors where foreign investment into China is either prohibited, restricted, or subject to greater scrutiny by regulators. The FIL has shortened the negative List, relaxing foreign investment restrictions in certain industry sectors such as financial services, automobiles, transportation, energy and resources.
“This is certainly welcome, as more areas have been opened up to foreign investment, and [there are] fewer and fewer areas of prohibition and restriction on foreign investment,” says Fang. “If I compare this [shortened negative list] with other jurisdictions such as the US and European countries, and compare it also to developing countries, China has an average ranking in terms of the length of the list… I expect with the new law, there will be continued efforts to further shorten the list.”
Intellectual property transfer. One of the most debated areas in the media last year was the discussion about foreign companies requiring to transfer their intellectual property (IP) to domestic partners before being able to do business in China. However, there are some misconceptions.
“It should be noted that there is no law that forces companies to transfer their IP rights over to a local company,” says Ulrike Glueck, managing partner of CMS China’s Shanghai office. “However, foreign companies may voluntarily do it because it gives them more bargaining power.”
Roules, at Squire Patton Boggs adds, “It is important to accept that if a foreign company chooses to transfer technology in consideration for its equity position in a joint venture, rather than contributing its proportionate share of cash, that is not a forced technology transfer.” He says the new law states that, “The state shall protect the intellectual property rights of foreign investors and foreign-funded enterprises, and protect the legitimate rights and interests of holders of intellectual property rights and relevant right holders; in case of any infringement of intellectual property right, legal liability shall be investigated strictly … in accordance with the law.”
However, the FIL and the implementing provisions do not go far enough, says Roules. “It fails to offer any details, nor are there effective means to enforce the prohibition on forced technology transfers by administrative agencies.”
Roules says the consolidation of the rules governing the above-mentioned activities under a single law and regulatory framework will enhance transparency. “The FIL applies to foreign investment in all forms, covering not only formation, but also M&A and so-called ‘indirect investment’,” he says. “Earlier, M&A and other investment topics were addressed in various regulations, some unique to particular industries, which was convoluted and confusing.”
The introduction of a post-reporting system of foreign investment removes the uncertainty attached to the earlier approval process, notes Fang, “not only because investors need not worry about whether the project will eventually be approved, but also because the Foreign Investment Management Department will not have the right to review the specific business arrangements between Chinese and foreign shareholders. An after-the-fact reporting system would give the Chinese and foreign parties full autonomy in determining the terms of their co-operation in accordance with commercial intent.
“For example, because of the original approval system, the granting of an option arrangement [such as an increase in equity interest granted by one party to the other] is subject to approval by the commercial authorities at the time of the transfer of equity interest. There is a difference of opinion as to whether the establishment of such an arrangement constitutes an essential provision of the joint venture contract and, therefore, requires approval by the authorities, which in itself lacks specific criteria, and is subjective. This creates uncertainty in the establishment and exercise of such option arrangements, often resulting in the parties being forced to abandon it, or doing it through other indirect and controversial means.”
Autonomy of contract. It should be noted that although there are substantial changes to the law, these arrangements are still contractual in nature. “These are new modes of foreign investment, new modes of owning investments in China, and adopting it has not been carved out,” says Fang. “This will depend on the contractual arrangement between the parties. It will be interesting to see how contractual arrangements and how indirect investment will be controlled at the domestic level.
“Under the premise of ensuring the management of foreign investment in accordance with the law, it is possible to promote the validity of contracts related to foreign investment, which will greatly safeguard the legitimate interests of investors and increase the judicial protection of cross-border commercial arrangements.”
There is one additional caveat. These laws, like any laws, are all subject to interpretation. The Supreme People’s Court is able to issues interpretations on the application of the FIL in order to uphold the principals of the law.
In the end, “parties should always choose their partners very wisely, as these laws are quite vague and may not afford adequate protection of foreign parties in all circumstances,” says Glueck.
To the view that the laws are broad and sometimes vague, Fang offers the following explanation: “In practice, the law is broad enough to entertain different types of foreign investment.”
The law can be quite flexible, so it can adapt to different types of foreign investment. Possibly, this may just demonstrate that “China is interested in getting foreign investment and the FIL wants to create a win-win situation,” says Glueck.
Where is the detail?
“While the implementing regulations and other supporting documents have, to some extent, provided further details and guidance regarding the implementation of the FIL, they are still rather vague in many aspects and there are still open issues,” says Glueck.
“For example, the meaning of ‘new projects’ as referred to in the definition of foreign investment in article 2, paragraph 3 of the FIL is still unclear, and many provisions, for example the ones regarding the safety review system and complaints mechanism, still appear incomplete,” she says.
The new regime allows for a mechanism to resolve complaints with government institutions. This consists of administrative reconsideration and administrative lawsuits. However, the argument has been that these stipulations are vague, and lawyers expect that the authorities will issue additional measures or circulars on how such a complaint system will actually work and be implemented in practice.
According to the implementation regulations, “A foreign investor or a foreign-invested enterprise may, if it believes the normative documents as the basis for any administrative action that are formulated by a department under the State Council or a local people’s government and its department to be illegal, request an examination of such normative documents concurrently while filing a lawsuit against the administrative action in accordance with the law.”
The implementation regulations also state that, “The competent department for commerce under the State Council shall, in collaboration with other relevant departments under the State Council, establish a foreign-invested enterprise complaint working mechanism and promptly handle issues with significant impacts nationwide.”
Roules says these implementing regulations “add little clarification to the broad statements of the FIL. The regulations leave open many questions. For example, most of the statements regarding equal protection for foreign investment (article 6), continuous improvement of foreign investment service (article 8), equal right to participate in the formation and revision of standards (article 13) do not meaningfully elaborate on what was already in the FIL.
“In addition to the lack of clarity and specificity in the content of the regulations, several important topics are not addressed at all. For example, with foreign and domestic-invested entities treated equally, will the concept of total investment currently applicable to foreign-invested entities be retained? And if so, will it continue to serve as a constraint on foreign loans, as it has in the past?
“Similarly, will the currently applicable M&A regulations promulgated by the Ministry of Commerce be retained or replaced? Further, will foreign-invested companies continue to be permitted to import equipment duty-free? We look forward to seeing, in the future, clarifications of these important issues.”
Adds Glueck: “It is expected that considerably more rules and regulations will be issued in the nearer future to provide more clarity and guidance on the new foreign investment regime in the PRC. In our view, only after the publication of such additional rules and regulations will the real impact of the FIL, and the implementing regulations, be seen, and only then it can be assessed whether the new foreign investment regime brings along significant improvements for foreign investment in the PRC compared to the old system, or not.”
While under the FIL, generally foreign-invested companies will be entitled to equal national treatment, except when investing in those industries specified on the negative list, it is not all positive generalities.
“It is clear that equal treatment of domestic and foreign investment in terms of government procurement, standard setting, etc., is a reassuring thing for foreign investors, although many foreign investors still have doubts about this,” says Fang.
“Some provisions of the new law may be unattractive to foreign investors,” notes Roules. “For example, article 8 requires the establishment of a trade union, and conducting trade union activities in accordance with applicable law. The applicable law specifies, among other things, that if established, a labour union must ‘take economic development as their central work, keep to the socialist path, uphold the people’s democratic dictatorship, the leadership of the Chinese Communist Party, Marxism-Leninism, Mao Zedong Thought and Deng Xiaoping Theory’.”
There may also be other situations where foreign companies find that being treated as the equal of their Chinese counterparts is more burdensome and problematic, he says. “Neither the FIL nor the draft implementation rules address what happens with any existing preferences available to foreign-invested entities [FIEs].
“For example, FIEs presently have the ability to borrow foreign loans to the extent of the difference between their total investment amount and their registered capital. Domestic companies have no such concept and no such right. Further, an FIE has the right to import equipment duty-free, whereas a domestic company does not.
“As another example of changes that may not be welcomed by FIEs, the FIL also provides that a foreign investor may, ‘according to the law’, freely transfer into or out of China renminbi or foreign currency,” he says.
“In times when PRC banks were strictly enforcing forex conversion quotas on domestic companies, we have sometimes seen foreign-invested clients that were able to convert and transfer moneys abroad. If the new FIL means that foreign-invested companies will now be subject to the same rigid quotas as domestic companies, it is likely to be less desirable.”
Similarly, Roules says the authorities have sometimes been more flexible in applying data privacy and cybersecurity requirements to foreign-invested companies than domestic ones, but if all companies are truly equal under the law, foreign investors may find themselves longing for the past.
Fang, however, is optimistic. “The FIL is far from perfect, but it is a beautiful blueprint for foreign investment in China,” he says. “The overall message is that people should be optimistic. But given how big China is, there will be hiccups in the actual implementations of dealing with various government authorities. I am hopeful that this can be resolved actively. There will be challenges.”