CHINESE UPDATE – National Security Review – A New and Important Part of the Approval Process for Foreign M&A in China
- A framework for reviewing foreign M&A transactions which may contain a national security component has been established under several pieces of legislation. The legislation contains a relatively high-level outline of the filing procedure, application documents, as well as a timeline of the review process.
- The Chinese authorities maintain broad discretion to conduct national security reviews of foreign investments in China on a case-by-case basis.
- The national security review process has become an important component in the whole approval process for foreign M&A transactions in China. A foreign investor planning to carry out M&A deals in China should pay particular attention to this regulatory process.
On 3rd February 2011, the General Office of the State Council issued the Circular on the Establishment of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (“Circular No.6”), which serves as the foundation of the “national security review system” in China.
On 25th August 2011, having gathered some practical experience based on an interim regulation and collected a large number of comments from interested parties during the trial implementation period from March to August of the same year, the Regulations on the Implementation of the Security Review System for Merger and Acquisition of Domestic Enterprises by Foreign Investors (“Circular No.53”) was issued by the Ministry of Commerce (“MOFCOM”). Circular No.53 lays down a relatively high-level description of the filing procedure, application documents, examination process as well as a timeline for the review.
Following the introduction of Circular No. 6 and Circular No.53, the key legal provisions relating to the national security review system are as follows:
A. Applicable Industries
According to Circular No.6, the security review process shall only be applied to mergers and acquisitions (“M&A”) involving enterprises belonging to any of the following:
(i) a military or related enterprise, or an enterprise located around key and sensitive military facilities, or any other entity the existence or operation of which may constitute a national defense concern; or
(ii) an enterprise operating in industries concerning significant agricultural products, significant energy or natural resources, significant infrastructure and transportation services, key technologies and the manufacturing of material equipment, the existence or operation of which may raise national security concerns,
((i) and (ii) together the “Sensitive Industries”).
In respect of an enterprise falling within the above item (ii), the application of the security review process is limited to such circumstances where the M&A may result in the acquisition of actual control over the relevant enterprise by the foreign investor(s).
Neither Circular No.6 nor Circular No.53 contains any definition or clarification of the terms “significant”, “key technology” and “sensitive” and therefore the examination authority retains a relatively high degree of discretion in determining whether any particular transaction is subject to the national security review. We understand that MOFCOM may have already issued an industry catalogue for its internal reference in determining whether a security review is needed. However, this catalogue is not available to the general public and may be subject to amendment by MOFCOM from time to time without any prior notice to the general public.
B. Transactions Covered
According to Circular No.6, the following are the particular transactions where a security review will apply, provided that other thresholds (e.g. control) are also satisfied:
(i) the purchase by a foreign investor of existing equity interests or shares, or the subscription by a foreign investor for increased capital, of a non-foreign invested enterprise in China which may lead to the transformation of such domestic enterprise into a foreign invested enterprises (“FIEs”);
(ii) the purchase by a foreign investor of equity interests or shares owned by a Chinese party in a FIE or the subscription by a foreign investor for increased capital of a FIE;
(iii) the purchase by a foreign investor of assets owned by a domestic enterprise through a FIE established by such foreign investor to acquire and operate such assets, or the purchase by a foreign investor of equity interests in such domestic enterprise through such FIE; and
(iv) the acquisition by a foreign investor of assets owned by a domestic enterprise, which will then be transferred to a FIE to be established and operated by a foreign investor.
Notwithstanding the foregoing, Circular No.53 has extended the potential scope of transactions that may be subject to the national security review by specifying that when determining whether a M&A transaction shall be subject to the review process, the substantial contents and actual impacts of the transaction, apart from merely its transaction form, shall also be taken into account. Accordingly, a foreign M&A transaction taking the form of a shareholder arrangement, trust, multilevel re-investment, lease, loan, variable interest entity (VIE) arrangement, overseas transaction, etc. may also be caught by the security review requirement.
C. Actual Control
A foreign investor will be deemed to have acquired the actual control of a domestic enterprise when it becomes the controlling shareholder or actual controller of a domestic enterprise through an M&A, including:
(a) where the percentage of equity interests held by the foreign investor, its parent company and subsidiaries in aggregate in the acquired domestic enterprise reaches 50% or above;
(b) where the percentage of equity interests held by several foreign investors in aggregate in the acquired domestic enterprise reaches 50% or above;
(c) where the percentage of equity interests held by foreign investors in aggregate in the acquired domestic enterprise, while not exceeding 50%, enables them to exert significant influence on the decisions of the shareholder meetings or the board of directors of the enterprise; or
(d) other situations where effective control over the domestic enterprise such as the rights to direct the operation, finance, and technology of the enterprise will be changed to the foreign investor(s).
D. Examination Authorities
- MOFCOM: the authority responsible for receiving the filing of security review applications and conducting preliminary reviews.
- Joint Committee: an inter-ministerial joint committee composed mainly of officials of MOFCOM and the National Development and Reform Commission (NDRC) will further examine and decide on the M&A transactions that are singled out by MOFCOM as involving possible national security concerns.
- State Council: the State Council will conduct a further review over special foreign M&A deals referred to it by the Joint Committee.
E. Filing Process
The following flowchart illustrates the filing process and associated timelines.
Notes to the flowchart:
1. Who will trigger the national security review?
There are mainly three ways to trigger the national security review process:
(a) an application by a foreign investor of its own volition;
(b) an application by a foreign investor upon the request of the relevant local counterparty of MOFCOM; and
(c) a request by a third party (such third parties may be the relevant ministries of the State Council, business associations, competitors or other related enterprises).
2. You may consider conducting a pre-filing consultation.
A foreign investor may apply to MOFCOM for a consultation with regard to the proposed acquisition of a domestic enterprise before it files a security review application for such deal. The pre-filing consultation will help to seek clarifications from the relevant MOFCOM officials on a particular deal. Notwithstanding this, such consultation is not a prerequisite of the national security review process and the information obtained from such consultation does not have any legal binding effect and therefore cannot be relied on as a legal ground for making or refusing to make a formal filing.
3. How will a review result impact on a deal?
(a) For a transaction which will not jeopardize national security: the applicant may proceed with the deal.
(b) For a pending transaction that may cause adverse impacts on national security: the deal shall be terminated. The applicant will not be allowed to complete the deal unless it has adjusted the structure of the deal, amended the filing documents accordingly, and re-applied for and passed the national security review.
(c) For a completed transaction that has caused or may cause adverse impacts on national security: the deal shall be void or other necessary remedial actions such as a transfer of the relevant equity interests or assets will be required.
With the establishment of the national security review system, a foreign investor planning to carry out M&A deals in one of the Sensitive Industries (as defined above) needs to take this review requirement into account when deciding on its transaction arrangements. Attention should also be paid to the right conferred by Circular No.6 on third parties to file a request for the national security review process against any particular deal.
In addition, the legality of a foreign M&A transaction structured through a VIE arrangement has for a long time been a subject of discussion. In response to this, MOFCOM, by issuing Circular No.53, for the first time has explicitly acknowledged that it is aware of the situations where the restriction on foreign investments in certain industries has been circumvented through the VIE arrangement. Nevertheless, Circular No.53 does not provide any further clarification over the clause concerning VIE arrangements. Up until this moment, no national security review precedent disclosed by MOFCOM concerns a VIE structure. A close eye has to be kept on any sign from the relevant authority over the issue.
- To address issues of sufficient protection for farmers’ property rights, tensions and conflicts arising from land rights, and monopolies on land supply that cause systematic corruption, China’s Ministry of Land and Resources (MLR) approved Beijing and Shanghai to start a pilot program on building and leasing residential properties on rural land.
- The pilot policy aims to create opportunities for investors and developers. The pilot policy allows farmers to adopt various methods to build and lease residential properties. Farmers may build and lease by themselves, or rent their land to developers/investors for the purposes of building and leasing, or alternatively set up a joint venture with investors or developers by contributing their land to the joint venture.
For many years China has been implementing separate policies for urban and rural land, under which urban and rural land are governed by different legal systems and governmental authorities and are traded in different markets and have different rights. Use of farm land for non-agriculture purposes is monopolized by government. Rural land to be used for urban construction needs to be expropriated from farmers first and then to be sold to land users by government. Government benefits from this process, i.e. government pockets differentials between land premiums paid by land users on the one side and compensation paid to farmers plus infrastructure development costs incurred by government on the other. Farmers do not have a say in expropriation process and their property rights might not be fully protected. The dual-track land policy in recent years has contributed greatly to high speed industrialization and urbanization of China. But its problem is obvious: there is a lack of sufficient protection for farmers’ property rights, tensions and conflicts arising from land rights continue to aggravate, and a monopoly on land supply causes systematic corruption among governmental officials.
At the beginning of this year, the Ministry of Land and Resources (MLR) approved Beijing and Shanghai to start a pilot program on building and leasing residential properties on rural land. We believe that this move is a significant breakthrough of the existing land policy and may open a door for farmers to participate in urbanization.
Highlights of the pilot policy are summarized as follows:
- Counties or villages may use rural construction land (non-agriculture land) to build and lease residential properties, to which counties or villages will own the title.
- The first pilot program in Beijing has been launched at Tangjialing Village, Haidian, under which the village will build and lease 100,000 sqm residential properties on its land. Upon the completion of construction work, Haidian Low-Income Housing Centre (a government agency) will rent the entire project and operate it as low-income housing. The first pilot program in Shanghai will start in Chongming, Qingpu, Baoshan and Fengxian, building and leasing residential properties with total gross floor area reaching 1,000,000 sqm.
- Counties or villages may choose different methods to build and lease residential properties on rural land. They may independently develop residential properties on their land, or contribute their land as equity to a joint venture, which will develop residential properties, or lease its land to developers or investors to build and lease.
- The development and operation of residential properties on rural land will be covered by the construction plan for low-income housing and will be entitled to certain tax incentives from government.
Underlying Reasons for the Pilot Policy
The tension and division in the land market has acted as a catalyst for the MLR to deviate from the dual-track land system and release the pilot policy. On the one hand, government is under great pressure from the aspects of land and capital in connection with building low-income housing. Building and leasing residential properties on rural land would help to lower land costs and alleviate imbalances between supply and demand for residential housing in urban areas. In addition, by allowing farmers to build and lease residential properties and benefit from rental income, the pilot policy should help to avoid tensions and conflicts arising from expropriation of rural land by government.
The pilot policy aims to create opportunities for investors and developers. The pilot policy allows farmers to adopt various methods to build and lease residential properties. Farmers may build and lease by themselves, or rent their land to developers/investors for the purposes of building and leasing, or alternatively set up a joint venture with investors or developers by contributing their land to the joint venture. The advantages for renting rural land or setting up a joint venture with farmers include the followings:
- Because there are no land premiums, or taxes and fees to be collected by government, land cost is lower compared with renting and acquiring stated-owned land.
- A majority of rural land included in the pilot program is located in the proximity to urban area and there are relatively mature infrastructure facilities. As a result, the infrastructure costs are expected to be lower than other rural areas.
- Government will grant certain tax incentives for building and leasing residential properties on rural land.
- There is great need for low-income housing in the market. For example, in 2010, Qibao County (Minghang district, Shanghai) has built and leased a residential project called “Lianming Yayuan”, with over 300 one-bed-room units. Qibao County rented Lianming Yayuan to its neighboring manufacturers as staff dormitories and has maintained 100% occupancy since its opening.
Possible Expansion of the Pilot Policy
According to the head of MLR, subject to the approval of MLR, the municipalities directly under the central government and a few vice-provincial cities (these cities are subject to the administration of the relevant provinces but economic and social development planning can be made separately from the provinces), whose housing prices are relatively high and which lack sufficient urban construction land, may implement a pilot program to build and lease on rural land. In May of this year, MLR will finalize a list of cities permitted to implement the pilot policy. We expect that the pilot policy will spread beyond Beijing and Shanghai in the near future.
- The paper discusses the strategic developments in the Russian legal and tax landscape that may have an impact on M&A environment.
- In Q1 2012 issue GBLP discusses the top 6 legal and tax developments that happened during the first quarter of 2012, as well as provides M&A tax and legal tips, including a comparison of how representation and warranties work under English law versus Russian law regimes (which is based on a recent book on the subject published by Alpina Publishers, and authored by GBLP corporate partners Ian Ivory and Anton Rogoza).
To see the full report, Russian M&A Legal and Tax Digest, please click Report
UK UPDATE – Understanding and Dealing with Hedge Funds and Shareholder Activism Across Europe: The Impact of the Financial Crisis
The attached guide takes a pan-European look at trends and developments through the 2008 financial crisis and in the period since, focusing on:
- the position of hedge funds: their behaviour, performance and strategies in that period, as well as the changed regulatory landscape they now face, and
- activist behaviour by both hedge funds and other investors during that period.
The Draft Amendment contains substantial changes to the Civil Procedural Law, with an aim to solve many practical problems in civil trials from small claims to enforcement. One of the fundamental legislative purposes of the current amendment is to provide more rights to Chinese citizens in civil trials, and to make the country’s civil trial system more transparent. It is also observed that the proposed amendment published for public comments has drawn heated public debates on many issues from both the general public and legal professionals.
In recent years, China has continuously reformed its legal system, and has gained significant experience in judicial practices. However, China continues to meet new challenges to be addressed by new or amended laws. Against this background, the Draft Amendment to the Civil Procedural Law of the PRC (the “Draft Amendment”) was published for public comments on October 29, 2011. When the final amendment is promulgated, it will be the first time that the PRC Civil Procedural Law is substantively amended since its enactment in 1991, and it will have a major impact on how civil disputes will be handled in China. We list below some of the most important changes and supplements introduced by the Draft Amendment.
Pre-trial Mediation in Civil Procedure
Mediation is an important form of judicial practice in China. A Court will often attempt to mediate during the trial of a civil case, because it is a traditional and efficient way to resolve disputes between the parties while maintaining their future relationships. If a settlement is reached, the court can render a judgment based upon the settlement agreement (a consent judgment), which is directly enforceable.
China has a long-established system of “the People’s Conciliation Committee,” whose main function is to receive requests from parties to mediate a dispute before trial. A settlement reached under the guidance of a conciliation committee is not directly enforceable. In recent years, as China’s economy is continuing to grow, caseloads in court are becoming increasingly heavy. The Draft Amendment attempts to resolve this problem by creating a new mechanism for formal pre-trial mediation. Before the trial begins, the court may try to settle disputes that have not been handled or resolved by the People’s Conciliation Committee. If successful, the court can directly issue a settlement agreement that is enforceable. A trial is no longer necessary, thereby saving judicial resources.
Public Interest Litigation
The PRC Tort Liability Law enacted in 2010 grants Chinese citizens the statutory right to sue companies for tort damages. However, for most claims that involve environmental pollution and food safety, individuals who act as the plaintiffs are in a weak position against large corporate defendants. To better protect the interests of individual victims and to prevent further injury to the general public, the Draft Amendment proposes to grant relevant institutions and social organizations a legal standing to file lawsuits where public interests are at stake. The Draft Amendment limits public interest litigation to cases involving environmental pollution and consumer rights.
Access to Court Records
China is primarily a “civil law” jurisdiction, with a system that uses statutes as the major source of law and does not officially recognize the authority of precedents as in the common law system. Nonetheless, the capability to make a reference to decided cases similar in facts and legal principles can provide significant guidance for winning an argument before a court in practice. Thus far a problem has been that court records are not open to the public but are only available to the parties for their own cases. To solve this problem, the Draft Amendment proposes that all the final judgments and rulings be made accessible to the public. Understandably, more transparency will improve the quality of trials, and judgments and will provide parties with more opportunities to cite cases as a reference when arguing in court.
One of the most-cited challenges to the civil litigation system in China is the difficulty to enforce a judgment. In practice, judgment creditors will gather and provide to the court relevant information on the locations of judgment debtors’ properties, while on the other hand it is relatively easy for a debtor to evade enforcement measures. To better protect judgment creditors, the Draft Amendment increases the maximum financial penalty for bad-faith evasion of enforcement up to RMB 100,000 for an individual and up to RMB 1 million for an entity. The Draft Amendment also proposes to introduce detention measures as a form of penalty and suggests that a party that intentionally evades the enforcement of an effective judgment or arbitration award could face criminal liability.
In addition, the Draft Amendment proposes to introduce a new procedure of “pre-judgment enforcement” by plaintiffs. Besides property preservation, a plaintiff can also apply for a pre-judgment injunction to require a defendant to do or refrain from doing specific acts.
The above features are only some of the highlights of the Draft Amendment. Other interesting amendments are also important, including new rules on evidence production, on making small-claim judgments final at the trial court level, and on requiring courts to provide written reasons for refusal to hear a case. It remains to be seen which parts of the Draft Amendment will eventually become law, but this initiative has already drawn much publicity and heated public discussions on some topics.