China's foreign investment law: A level playing field?

A mere three months elapsed between the publication of the final draft of China’s new Foreign Investment Law (FIL) and its passage into legislation – a remarkable turn of speed in a country where the policymaking wheels can turn very slowly. The haste has been linked to Beijing’s desire to cool the trade tensions with the US and encourage capital flows from overseas at a time when the economy is slowing.

The FIL, which was approved by the National People’s Congress last month, is notable for effectively putting foreign and local companies under the same set of regulations for the first time. The foreign-invested enterprises (FIEs), joint ventures and wholly foreign-owned enterprises (WOFEs) that have defined overseas participation in the Chinese economy will be no more. The Company Law or Partnership Enterprise Law, which also apply to domestic businesses, will be the go-to statutes.

The new approach is expected to bring fairer treatment for foreign investors. Changes involving a company’s highest authoritative body, profit distributions between shareholders, and share transfers, for example, are expected to allow greater flexibility. But at the same time, uncertainties remain around what kind of structures can be used by investment vehicles and portfolio companies in China.

A more detailed memo – set to be published by January 1, 2020, when the law will take effect – will likely offer answers to some of the outstanding questions. For now, though, investors and advisors are still largely in the dark. Those looking to take substantive action may wait until the dust settles.

“In general, the new draft rules make foreign investors equal to local Chinese investors. However, some say that while the overarching principle is great, the new rules lack detailed guidance, which can be problematic as it allows regulators to have wide discretion for arbitrary interpretations,” says one Beijing-based lawyer.

Welcome flexibility

The move to make shareholder meetings, rather than boards of directors, the highest authority within a Sino-foreign joint venture company is among the most significant reforms. Whereas previously unanimous approval at board level was sufficient for passing share transfers or provisions of company rules, now these issues will require the green light from two-thirds of the shareholder base.

“In the short term, this means foreign PE and VC investors, many of whom are minority investors in companies, will have less power, as they cannot block proposal via board meetings as easily as before. But in the long run, this is a positive change because it reduces the chances of other minority shareholders obstructing the daily operations of portfolio companies,” says Zhi Bao, an M&A Partner at FenXun Partners, who worked for seven years at the Ministry of Commerce before entering private practice.

As for the distribution of profits, the new law allows shareholders to make agreements on their own terms, rather than based on the proportion of their committed capital in a company. “This appears to leave room for PE and VC investors to design priority dividend distribution arrangements like is sometimes done in the UK, Singapore or Hong Kong,” says Grace Tso, an M&A Partner at Baker McKenzie.

The changes to share transfer rules also suggest greater flexibility for investors. Previously, they would need to obtain approval from all shareholders in a portfolio company before transferring ownership. Now, they only need consent from more than half of the shareholders, potentially paving the way for smoother exits.

VIE uncertainty

A key area that still lacks clarity is variable interest entity (VIE) structures, which are series of contracts used to give overseas investors can get exposure to industries where foreign participation is restricted. An early draft of the FIL, published in 2015, implied that the structure would become unworkable because any domestic entity controlled by a foreign investor – through contracts, trusts, or other means – would be treated as a foreign-owned entity.

However, this was quietly removed from the final version and the consensus view is that Beijing is unlikely to outlaw the structure all of a sudden. Instead, it will gradually be phased out or replaced over the next few years.

“If the regulator now decides all companies with VIEs are foreign-invested entities, this is likely to cause huge shock to China’s capital markets. One of the headaches for the regulator would be how they handle the massive number of companies that have adopted VIEs over the past 15-20 years and operate in fields deemed sensitive or even negative for foreign investors,” says Qing Zhao, a private equity and venture capital partner at Hengdu Law Firm.

According to several industry participants who have spoken to regulators, Beijing has realized the importance of maintaining VIEs. Any change could result in class action lawsuits filed by overseas investors who hold shares in US-listed Chinese companies with VIEs that are forced to tear them down. Alternatively, if a business is classified as a foreign-owned entity, uncertainty over its future participation in an industry could hinder attempts to raise capital and lead to massive layoffs.

However, this willingness to maintain the status quo cannot be interpreted as a guarantee for VIEs to operate legally. The FIL leaves room for the structure to be altered at a later date if the regulator so desires.

“[The FIL] lacks details around the treatment of various forms of foreign investment. The definition of ‘indirect investment’ is not clear and thus the concept could be interpreted by the Chinese authorities to cover VIE structures in the future,” says Karen Ip, corporate partner at Herbert Smith Freehills in Beijing.

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