Executive Summary/Highlights:

• Under China State Council’s recent Notice, the National Security Review regime will only apply to foreign domestic deals where (a) the target domestic business is involved in a business that concerns national defense security; or; (b) the target domestic business is involved in a business that concerns national economic security, and the foreign acquiring business intends to acquire de facto control of the target domestic business.
• Neither of the terms “national defense security” or “national economic security” are defined in the Notice, presumably in order to give the regulators flexibility.
• Pursuant to the Notice, a foreign business (or a group of foreign businesses) acquires de facto control over a domestic company when it or they: (a) acquire 50 percent or more of the shares of the target domestic company; (b) otherwise has significant influence or operational control over the target domestic company

I    Introduction

On 3 February 2011, China’s State Council released a notice which, for the first time, formalizes and sets out a national security review (“NSR”) process for foreign acquisitions of domestic companies in China. This notice is entitled “Notice by the General Office of the State Council in relation to the institution of the National
Security Review system for mergers and acquisitions of domestic enterprises by Foreign Investors”[1] (“Notice”). This Notice (and consequently, China’s NSR regime) came into force on March 5, 2011. This article sets out in some detail the boundaries of China’s NSR
regime.

II    Background

As mentioned above, the Notice contains the precise boundaries as to how the NSR regime will operate. Thus far, it is not clear if any deals (or any deals for that matter) have come under the scrutiny of this regime.

On March 4, 2011, China’s Ministry of Commerce (“MOFCOM”) (the primary coordinating agency in charge of overseeing or coordinating the national security review process) published rules entitled “Interim Rules for Implementation”[2] (the “Interim Rules”) detailing how the NSR process will be initiated, the types of documentation to be submitted (in relation to an application for an NSR), and the manner in which the NSR will be conducted.

The Interim Rules is only active for approximately five months. During such time, the effect of the Interim Rules was tested by MOFCOM. On 25 August 2011, MOFCOM released the MOFCOM Rules for Implementation of Relevant Issues regarding National Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “NSR Rules”)[3]. The NSR Rules replaced the Interim Rules as of 1 September 2011.[4]

In fact, the concept of scrutinizing foreign-domestic deals for “national security” issues is not new in China. This concept was first formally introduced by regulations entitled “Provisions re Guiding Foreign Investment 2002”. Article 7 of the aforementioned provisions prohibits foreign investment that might jeopardize China’s national security. Further, Article 31 of the Anti-Monopoly Law also states that all foreign funded mergers and acquisitions of domestic businesses will be reviewed for national security issues in accordance with rules set out by the Chinese government. Until the enactment of the Notice, the Interim Rules, and the NSR Rules, however, there has never been any visibility or transparency in relation to how China’s NSR regime would be conducted.

III    Will All Foreign-Domestic Deals Be Caught by the NSR Regime?

Pursuant to the Notice, the NSR regime will only apply to foreign domestic deals, provided:

a) the target domestic business is involved in a business that concerns national defense security (“national defense security businesses”); or
b) the target domestic business is involved in a business that concerns national economic security (“national economic security businesses”), and the foreign acquiring business intends to acquire de facto control of the target domestic business.

National defense/economic security. In relation to (a) above, neither the term “national defense security” nor the term “national economic security” (or even “national security” for that matter) have been defined within the Notice and the NSR Rules.

The Notice does state, however, that national defense security businesses would include businesses which operate within the military industry and businesses which are located adjacent to major or sensitive military facilities. In relation to national economic security businesses, the Notice states that these could include businesses which deal with: major agricultural products; the major energy and resources sectors; “important” infrastructure; transportation services; and “key” technologies as well as other “key” manufacturing equipment which have to do with national security. The Notice makes it clear that the above lists aren’t exhaustive.

We think the “national defense security businesses” and “national economic security businesses” categories haven’t been defined in the Notice or in the NSR Rules so that this gives adequate room for the authorities to bring into line a transaction which may impinge on national security.

One useful point of reference, in the meantime, is to look at past decisions, regulations and guidance notes from government agencies, including the State Council, MOFCOM and the National Development Reform Commission (“NDRC,” another agency who is expected to be involved in the NSR processes) in order to get a hint of the types of businesses that could fall under the above mentioned categories.

For instance, in 2006, the State Council issued the “State Council’s Opinions on Revitalizing the Machinery Manufacturing Industry” which lists out 16 categories of businesses the Chinese Government considers could have a significant impact on national economic security and national defense construction. These include businesses which involve: power generation equipment; power transmission and transformation equipment; coal or mining industry equipment; marine oil engineering equipment; the high-speed train; environmental protection equipment; textile machinery; and agricultural equipment.

Another instance of a document which might be referred to in the context of figuring out which businesses fall into the national defense or national economic security businesses categories is a press release issued by the State-Owned Assets Supervision and Administration Commission dated December 18, 2006, entitled “National Economy Should Maintain Absolute Control of 7 Industries”. In this press release, seven industries were identified as having a large bearing on China’s national security and the economy. These are: defense; power generation and distribution; oil; petrochemicals; telecommunications; coal; aviation; and shipping.

De facto control. Pursuant to the Notice, a foreign business (or a group of foreign businesses) acquires de facto control over a domestic company when it or they: (a) acquire 50 percent or more of the shares of the target domestic company; (b) otherwise has significant influence or operational control over the target domestic company. The Notice also sets out examples where the foreign business would have significant influence or operational control over the domestic business; these include where the foreign business has control over the resolutions of general meetings or shareholders meetings; making decisions in relation to the operations of the target; making decisions in relation to issues to do with human resources, finances and technology.

Overall, a transaction will fall under the purview of the NSR regime if:

• the transaction involves a foreign business merging with or acquiring a domestic business; and
• if the scope or nature of the domestic business involves national defense; or the scope or nature of the domestic business involves national economic security, and the foreign acquiring business intends to acquire de facto control of the target domestic business.

IV    Which Agencies Are in Charge of the NSR Regime?

The Notice stipulates that a ministerial joint committee (“Joint Committee”), led by the NDRC and MOFCOM will be set up to evaluate deals against the NSR regime.

V    How Would a NSR Be Initiated and by Whom?

The Notice stipulates that a NSR may be triggered either by the foreign business involved in the deal or upon request by third parties. The Notice contemplates that third parties could include government departments, industry associations and other businesses.

Both foreign businesses and third parties are expected to submit all applications to the Foreign Investment Division of MOFCOM for an initial review. If MOFCOM decides that the deal does fall within the purview of the NSR regime, MOFCOM will then submit the matter to the Joint Committee to commence the NSR process.

The NSR Rules provide that if transactions fall under the purview of the NSR regime, then foreign businesses should file the application with MOFCOM. If the merger or acquisition involves two or more foreign businesses, then these could file the application as joint applicants. It should be noted that from the way this provision is being phrased in the NSR Rules, it appears that the authorities consider that the foreign participants should be responsible to notify deals which might fall under the purview of the NSR.

Pursuant to the NSR Rules, once an application is filed with MOFCOM, MOFCOM will conduct an initial review in order to ensure that all necessary documents and materials have been submitted. MOFCOM will then send the applicants an “official acceptance.” After receiving official acceptance, the applicant is obliged to put the transaction on hold for 15 working days during which MOFCOM will determine whether the transaction should be passed onto the Joint Committee. If so, MOFCOM will notify the applicants and also notify the Joint Committee within five working days. If applicants do not hear from MOFCOM within 15 days, applicants may proceed to implement the transaction.

VI    What Are the Stages of Review?

Pursuant to the Notice, there are two stages of review in relation to the NSR process conducted by the Joint Committee: a “General Review” stage and a “Special Review” stage (if required).

General Review. First, the proposed deal will go through a General Review. This stage will span for a maximum of 30 working days from the date in which the Joint Committee receives MOFCOM’s application. During this period, the Joint Committee will determine if the proposed deal is clear of national security concerns or whether more time is required to evaluate the proposed deal. During this stage, the Joint Committee will also solicit opinions from other relevant government departments. The determination as to whether the proposed deal is clear of national security concerns or whether more time is required to evaluate the proposed deal will be determined by the number of government departments invited to join this process—all determinations will be adopted on a unanimous basis. In other words, if even one department is of the view that the proposed deal is likely to affect national security, the Joint Committee is obliged to move the deal through to the Special Review stage for further consideration and evaluation.

Special Review. This stage will span for a maximum of 60 working days. During this period, the Joint Committee will evaluate the deal in more detail. The Joint Committee will decide during this stage whether the proposed deal is free of national security concerns or whether there are national security concerns and the proposed deal is prohibited.

In fact, pursuant to the Notice, there are really three outcomes stemming from an NSR process:

• No Concern: the Joint Committee may decide that there are no national security concerns. The applicant may then go ahead and apply for all other regulatory approvals and close the deal.
• Some impact: the Joint Committee may decide that the proposed transaction has some impact on national security and ask that the applicant make the relevant amendments or revisions to the proposed deal such as to mitigate the impact on national security. After the relevant revisions or amendments are undertaken, the applicant will be asked to re-submit an application to the Joint Committee for another review, before the Joint Committee will clear the proposed deal.
• Major impact: the Joint Committee will prohibit the proposed transaction because the transaction either has had or will have a severe negative impact on national security. The Joint Committee may also undertake “measures” to eliminate such an impact on national security such as by asking the applicants and participants to undertake a transfer of shares or assets. It should be noted that the way the provision addressing this point is phrased in the Interim Rules, it would appear that the NSR regime contemplates dealing with both deals which have yet to be closed and deals which have already been closed.

We note that there is no mention in the Notice or in the NSR Rules in relation to whether the applicants may file for a review of the Joint Committees’ decision.

VII Flow Chart Summarizing the NSR Process

The following is a flow chart summarizing the NSR process.

Annex – Flowchart summarizing China’s NSR process

[1] See: http://www.gov.cn/zwgk/2011-02/12/content_1802467.htm

[2] See: http://wzs.mofcom.gov.cn/aarticle/n/201103/20110307432685.html

[3] See: http://www.gov.cn/gzdt/2011-08/26/content_1934046.htm

[4] Compared with the Interim Rules, the key change we see in the NSR Rules is that MOFCOM clearly states that the authority will assess the applicability of the national security review (NSR) process from the substance and actual impact of a transaction; and that foreign investors shall not evade the NSR regime via alternative transaction structures, including but not limited to warehousing arrangements, trusts, multi-tier investments, leases, loans, contractual control, or offshore transactions, etc.