Part II of this article will appear in the April issue of The Metropolitan Corporate Counsel.
While the recent financial turmoil in the U.S. credit markets badly impacts the availability of financing deals in the U.S. and the EU, the Chinese market will continue to be a marketplace to attract foreign investment. With the development of the Chinese economy and the ending of the five-year phase-in period of its last major WTO commitments, on the one hand more areas are opened for foreign investment, and on the other hand the Chinese government has been making an effort to strike a balance between introducing foreign investment to hasten the development of the Chinese economy while at the same time protecting national economic security. Overall, the Chinese market will become a more level playing field. But, doing business in China is vastly different from doing business in the U.S., and transactions in China by foreign investors are subject to a lot of Chinese regulations. Without full compliance with the Chinese law, your deal may be stymied at any point of the transaction. So it is important to understand the legal and regulatory landscape in China.
Change Of Chinese Industrial Polices On Foreign Investment
To every foreign investor investing in China, a threshold issue is whether the business area in which it plans to invest is open to the foreign investor; if it is open, then the next issue is how open is it. This threshold issue goes directly to the industrial policy of the Chinese government regarding foreign investment. The key legislation in this regard is the Catalogue Guiding Foreign Investment (the "Catalogue"). The Catalogue lists the business sectors where the Chinese government forbids, restricts or encourages foreign investment. Anything not mentioned in the Catalogue is deemed a sector that the Chinese government allows for foreign investment. If an investment falls into a "restricted" area, it usually means that it is subject to special governmental approval and that quite often the foreign shareholding in the investee company cannot exceed a certain percentage. In the case of an investment falling into "encouraged" areas, the investee company would be entitled to preferential treatment of customs duty and taxes. The Chinese government revised the Catalogue last December and the major changes can be summarized as follows:
(1) More areas are open to foreign investment. For example, foreign investment in futures trading companies and construction and operation of a power grid are no longer forbidden to foreign investment, but the foreign shareholding of the concerned company shall not be more than 50 percent.
(2) Foreign investment in purely export-oriented industries is no longer encouraged. Foreign investment in high-tech and clean energy industries and certain service industries (such as modern logistics) is now encouraged.
(3) For those industries involving non-renewable natural resources, foreign investment is either forbidden or restricted.
(4) For those business sectors which may impact the national economic security, such as news websites, services of Internet audiovisual programs, business sites that provide Internet access services and Internet culture operations, foreign investment is no longer permitted and now falls into the forbidden category.
(5) Foreign investment in the real estate market is subject to stringent regulation. Construction and operation of golf courses is forbidden now; foreign investment in the secondary real estate market, real estate property agents or brokerage companies is added to the restricted category; development and construction of ordinary residences is no longer an encouraged area and now becomes simply a permitted category for foreign investment.
How The Chinese Government Regulates Real Estate
Foreign investors and investee companies are subject to various laws and regulations that are enacted on a daily basis by different government authorities. Lack of consistency and predictability is still one of the biggest challenges of doing business in China. I will use the recent regulations on foreign investment in the real estate market to exemplify how challenging the change of regulation could be to foreign investors.
In order to cool down the overheated real estate market, six ministries jointly issued the famous Decree No. 171 in 2006. Following were a series of rules issued to implement the Decree. As a result of these new regulations, the financing of foreign investment in real estate enterprises is subject to very stringent regulation by the Chinese government.
The main points of these rules can be summarized as follows:
(1) A foreigner (company or individual) cannot purchase real estate properties in China without incorporating a "foreign invested real estate enterprise" in China unless the purchase is for its own use.
(2) "Foreign invested real estate enterprise" is defined in a very broad sense, including development, construction and/or operation of residential buildings, office buildings, theme parks, hotels, restaurants, etc. The definition of "foreign invested real estate enterprise" is not clear.
(3) For a "foreign invested real estate enterprise," a higher amount of the paid-in capital is required and lower amount of non-capital borrowing is allowed.
(4) No shareholder of a "foreign invested real estate enterprise" can guarantee a fixed return to the other shareholder(s) of the company.
(5) The "foreign invested real estate enterprise" must be filed with the Ministry of Commerce; without proper filing, the capital paid in by the foreign investor(s) cannot be converted into RMB. Any "foreign invested real estate enterprise" that is incorporated after June 1, 2007, cannot incur foreign debts.
This illustrates how important it will be for a foreign investor to get sufficient legal advice regarding the Chinese regulations before it decides on how to structure its transaction.
The New Legal Regime Of Franchising - Another Example Of How The Chinese Government Regulates Foreign Investment
While the Chinese government has been changing its policy on foreign investment, the overall tendency is that more and more areas have become open to foreign investment and more legislation will be passed to make the relevant transactions legally feasible. Here I use the new legal regime of franchising as an example to illustrate my point.
China is the biggest untapped market for international franchisors as shown by huge amounts of consumers in over 100 urban centers with a population of more than 1 million, low market penetration for international franchisors in most sectors and reported franchising growth of over 40 percent per annum in recent years. The spanner in the works has been the legal regime. Until recently, the law governing franchising in China was onerous and restrictive, preventing all but the most dogged and resource-rich franchisors from entering the market. This was changed in May of 2007. China's State Council enacted the new Chinese Franchise Regulation and the Ministry of Commerce issued two implementation guidelines of the Franchise Regulation. With the new set of laws, China will no longer be open just for the pioneers, and will finally open the frontier for the settlers proper.
Under the previous regime, there was a strict requirement that to franchise in China, foreign franchisors had to meet the so-called "2+1 rule," which meant that they had to have operated "two directly operated outlets" in which they held a greater than 50 percent equity stake within mainland China for over one year before they were eligible to franchise. Under the new regulations, though the "2+1 rule" remains, it is no longer an explicit requirement that the "two directly operated outlets" be in mainland China. A foreign franchisor may use "two directly operated outlets" outside mainland China to enable it to franchise in China.
Other changes include the provision that the franchisor is no longer required to bear joint and several liability for the quality of products provided by its designated suppliers.
National Economic Security Concerns In Mergers And Acquisitions
In contrast to two decades ago when the Chinese government's priority was to attack generally the quantity of foreign investment entering the Chinese market, now the government is becoming more concerned with the impact of foreign investment on the Chinese local market.
The issue of "national economic security" is one of the overriding issues in a high-profile transaction in which a U.S. company sought to acquire a stake in a Chinese company. The acquisition was fiercely opposed by another Chinese company; one of its claims was that the acquisition would harm China's economic security. As a result of the hearing, the U.S. company's equity ownership in the post-acquisition company was reduced from the initially proposed 85 percent to 45 percent; the Chinese target company will have a majority of members on the Board and will designate the chairman of the post-acquisition company.
The concept of "national economic security" was formally introduced to the Chinese regulatory landscape with the famous Decree No. 10 jointly issued by several ministries in September 2006. Article 12 of the Decree No. 10 explicitly states that
[I]f a merger with or an acquisition of a Chinese domestic enterprise by foreign investors and the foreign investors' obtaining of actual controlling rights of the target Chinese company (i) involves important industries, (ii) or has any factor that will impact or may impact the national economic security of China, or (iii) leads to a shift of actual controlling rights over the target Chinese domestic company that possesses "well-known trademarks" or "China Time-Honored Brand," then the parties concerned shall make a filing to the Ministry of Commerce in respect of such issues.
Decree No. 10 also explicitly provides for the consequence of failing to make a proper filing: if the contemplated merger or acquisition materially impacts or may materially impact China's economic security, the Chinese government may take measures necessary to eliminate such impact, including an order to terminate the transaction.
The newly enacted Anti-Monopoly Law also requires national security review if a foreign investor's acquisition of a Chinese enterprise concerns national security. And, under the Anti-Monopoly Law, "national security" refers to not only economic security, but also national defense security and culture security.
It should be noted that there is no specific guidance as to which business sector may concern "national security," nor is there any list of what constitutes "important industry" or "factor that will or may impact the national economic security." The Chinese government would like to maintain as much leeway as possible to interpret the application scope of "national economic security." So, if your investment in China touches upon sensitive national security issues, it is necessary to consult with your lawyers or advisors on this issue as early as possible.
Published March 1, 2008.