CHINESE UPDATE – The Draft Foreign Investment Law and Its Impact on VIEs

Executive Summary: China’s Ministry of Commerce released for comment major legislation, the draft Foreign Investment Law, to overhaul the regulation of foreign direct investment.  The article below discusses how these major changes could impacting foreign investment enterprises and variable interest entities.


The best way to understand the draft Foreign Investment Law (“Draft”), circulated by the Ministry of Commerce of the PRC (“MofCom”) on Jan. 19, 2015, is to read it in the context.  Fortunately for Jun He, we were invited by MofCom to participate in a number of discussions since 2013, and more than a dozen of our partners had been involved in giving feedback before the draft became public a few days ago.  Here is how we look at this Draft.

  1. Background:

It is clear the PRC government wants to shift the focus of the regulation of foreign direct investment (“FDI”, in the forms of equity joint ventures, contractual joint ventures, foreign invested enterprise, etc.) away from the case by case approval system.  The current foreign investment enterprise (“FIE”) laws focus more on the corporate governance, and the governance structure differs among different forms of FIEs, and these stipulations may also conflict with the Company Law that is supposed to govern all companies in China.  The MofCom and its local counterparts spend mountains of resources to review and approve each investment, and the super-majority of these reviews is just a matter of formality wasting roughly one month time.  On the other hand, things like national security often casually slip from the mind of the reviewer because, among other things, it is not the focal point of local government that is designed to attract, not to resist, foreign investment of any form.  The existing FIE laws seem quite lagged behind.  However, the biggest legacy of the PRC government is that there is competing interest among different government agencies, and without masterful communication and alignment of interest, any grand plan could easily result in a mere wishful thinking.

  1. The Draft

So, the Draft is a much calculated effort of MofCom to test whether its new master plan to regulate FIEs would be embraced by interested people.  These people include different regulators, at both national and provincial levels, and domestic and international businesses.  You can imagine there are a lot of lobbying forces.

The skyline under the Draft includes the following important parts:

  1. The gist of the new incorporation system is, unless you are in the Negative List (defined below), FIEs would not have to be approved to be incorporated. (Art. 26)
  2. There is a negative list to be provided by the State Council (“Negative List”), the executive branch of Chinese national government. (Art. 22) That is, the Negative List would have to consider all interests of different ministries of PRC, different localities and China’s treaty duties before it is launched.
  3. Negative List concerns size of the FDI or the intended investment industries. If an FDI warrants a review by MofCom, the review would be focused on national security (Arts. 48-74 are designated exclusively to codify the current national security review system), regulated industry, benefit to the general public or innovation, monopoly concern, treaty duties, background of the investors, etc. (Art. 32).  There is a time limit for review (usually 30 days).  Public hearings may be convened and appeals are available if review results in rejection or conditional approval.  (Arts. 35, 39 & 40)
  4. The Draft sets up a new information reporting system that requires foreign investors and FIEs to report, for example, their investment in stock markets, and change of investment profiles. (Arts. 75-99)
  5. The Draft assigns chapters to legislate promotions and protections of foreign investments, inspections of and complaints by foreign investors and FIEs. (Chapters 6,7, 8 & 9)  All these systems are novice to the whole FIE regulations, and it looks they are designed to create a more predictable investment environment.
  1. Implications on VIEs

While the Draft is new, many of the changes indicated in the law started to take shape a while ago.  For example, the national security review is already regularly practiced.  The Negative List has been adopted in China (Shanghai) Pilot Free Trade Zone (“FTZ”) for a while.  However, the change of the definition of foreign investment has raised the eyebrows of many.

In its Article 18(3), the Draft expands the definition of FDI to include contractual control by foreign investors.  If implemented, many companies, including more than 200 listed companies that use so called variable interest entities (“VIEs”), might have to go through structural changes.

VIEs are typically used to bypass Chinese restriction on certain market access to foreign investors, or make Chinese businesses available for foreign stock markets because these stock exchanges do not accept Chinese companies to be listed.  Many of the VIEs companies are in hi-tech, service industries or internet-related businesses.  The new definition would make it difficult for foreign investors to sneak into otherwise restricted industries.  That does not mean, however, the FDI investment is becoming generally more hostile to foreign investors.  The Negative List has gradually lifted restriction to foreign investors so the VIEs may no longer be necessary anyway.  Online retailing, a restricted business to foreign investors, is now opened up in the FTZ.  (See Jun He Bulletin, January 15, 2015, Shanghai Free Trade Zone, New Shanghai FTZ Policy Further Loosening Shareholding Restriction in E-commerce Sector, authored by Liu Ning) So, perhaps one has to look at interplays of different sets of rules before she can make an assessment if the Draft is more investor friendly or less so.

There are more than 200 companies listed in the U.S. stock market using VIE structures.  With the Draft, people may wonder whether these companies would have to undertake structural changes.  For such listed companies that are actually “controlled” by Chinese investors (defined in Art. 12), perhaps the change of the law would not be an issue because under the Draft, these FIEs in form would not be considered as owned by foreigners in substance.  For those actually “controlled” by foreign investors (definition in Art. 11), they may have to seek licenses for their VIEs from the government, and the government might not grant these licenses.  Would that mean all these companies have to be delisted?  We don’t know the answer, but remain optimistic.  Chinese government has been very pragmatic and the stake of VIE-related business is huge.  When China introduced the M&A Rules that regulated foreign investors’ acquisition of Chinese domestic businesses in 2006, they grandfathered the prior transactions.  In the MofCom’s explanatory remarks accompanying the Draft, they made it clear that MofCom would not rush into any decision simply to close down all the non-compliant VIEs if the Draft is actually promulgated as a law.  (Section 3)

We anticipate, based on our experience involved in many legislative exercises, that it would take a while for the Draft to be officially promulgated.  When it is launched, the Foreign Investment Law would probably be a different shape because MofCom will listen to different voices.  The Draft is a start of a public discussion, not the conclusion of it.