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.