China Releases Rules on Foreign Investment Security Review

On 19 December 2020, the Measures on Foreign Investment Security Review (“Measures”) were released by China’s National Development and Reform Commission (“NDRC”) and Ministry of Commerce (“MOFCOM”); they take effect on 18 January 2021. As anticipated by the Foreign Investment Law, passed in 2019 and effective from 1 January 2020, the PRC is elaborating a formal process for screening potentially “important” (as further elaborated below) foreign investments in China (“Security Review”) by a government mechanism (“Working Mechanism”) analogous to the Committee on Foreign Investment in the United States and the recently established “FDI screening” mechanism of the European Commission. The Measures, however, are relatively brief and devoid of details. With more detailed rules to be expected in future releases of the NDRC, MOFCOM, or local government agencies, the Measures only begin to sketch out the Security Review, whose application and impact may thus be limited for the time being. This Newsletter highlights key provisions and policy indications from the Measures while noting major points calling for further specification or clarification.

Which Investments May Be Subject to Security Review

The Security Review is aimed at “foreign investment”, which the Measures define broadly as investment activities conducted “directly or indirectly” by any foreign investor within the PRC, whether the investor obtains assets or equity of domestic enterprises, establishes its own foreign-invested enterprise (“FIE”), or “invests in China through other means”. Scope of this (obviously intentional) breadth (and vagueness) is not uncommon in PRC legal provisions, especially in recent years, and whether the Measures will indeed be applied to all types of investment activities (e.g., domestic re-investment by an existing FIE) cannot be answered until further rules or at least practices are seen.

Moreover, while the above scope (along with a provision permitting any third party to propose to the Working Mechanism that a given foreign investment should be reviewed) may in theory render every foreign investment subject to Security Review, the Measures require only certain investments to be reported by parties to the investments. Specifically, foreign investors (or relevant domestic parties, e.g., partners or target companies of the foreign investors) must report their proposed investments when either:

1. the investment is in the military industry, military industry support “or other areas related to national defense security”, or in military facilities and regions around military facilities; or
2. the investment (i) grants “actual control” of the enterprise invested in, and (ii) is in an “important/key” part of, any of the following industries: agricultural products, energy or resources, equipment manufacturing, infrastructure, transportation services, cultural products and services, information technology and Internet products and services, financial services, technologies “and other important areas related to national security”.

On the one hand, the Measures include the standard PRC catch-all provision “and other [important] areas related to national security”, and on the other hand, they do not give any indication of how, if at all, the qualifier “important/key” is to be assessed.

The Measures do provide a definition, albeit open-ended, of “actual control”:

1. foreign investors hold more than 50% of the enterprise’s equity;
2. foreign investors hold less than 50% of the enterprise’s equity but enjoy voting rights that can have a significant impact on the resolutions of the board of directors or shareholders; or
3. other circumstances leading to foreign investors having a significant impact on the enterprise’s business decision-making, personnel, finance, technology, etc.

Even without the open-ended catch-all provision, the standards of “actual control” provided in the Measures are (probably intentionally) broad and, similar to the definition of control used in the PRC anti-trust filings, leave much to interpretation when determining whether an investment grants “actual control. 

A major example comes from the inter-corporate structure called “variable-interest entity” (“VIE”) commonly used in PRC industries with foreign investment restrictions (e.g., TMT industries), whereby a domestic entity (even one none of whose equity is held by foreign parties) is controlled by an FIE via various contractual arrangements: as with the issue of re-investment, the Measures appear to be broad enough to apply to investment in controlling stakes of VIE structures, or even non-controlling stakes with certain protective provisions, such as veto rights, but whether or in which more specific circumstances they will be so applied remains to be seen.

In light of the apparent breadth of the Measures, however, and the reality of the flow of foreign investment into China – not to mention the avowed and manifest desire and intention of China to continue attracting it – the Measures clearly do not task the Working Mechanism to substantively review every foreign investment in China. In addition to the multiple stages of the process (see below), including therefore several relatively quick ways for reported foreign investments to be given a green light (without much, if any, review), the Measures in fact provide first and foremost for an interested party to consult with the Working Mechanism prior to any Security Review, probably intending to limit the actual filings submitted by screening out the transactions that are not “important” or “key” in the captured industries or otherwise not necessary for the Working Mechanism to review, through the consulting process.   Given the Chinese policy goal to promote global trade, it would be hard to imagine that the Working Mechanism would have such capacity and motive to review just any foreign investment.

It is also worth noting that security review is  not new to the PRC, but rather, like other countries (the United Kingdom, Australia, etc.), such actions have been more ad hoc and less transparent in the PRC in the past. Therefore, the Measures may rather be viewed as a legislative attempt to respond to the world’s rising trend of protectionism by the PRC government, and actually a rather belated one considering the recent cases surrounding Chinese investment in other countries.

One type of foreign investment is so far clearly excluded from Security Review: purchases, by foreign investors, of domestic enterprises’ equity via stock exchanges (or other securities trading venues approved by the PRC State Council), even if the purchase affects or may affect national security. The Measures provide that the China Securities Regulatory Commission in conjunction with the Working Mechanism will determine relevant rules, which we understand are still pending, for this type of foreign investment.

What Comprises the Security Review Process

The Working Mechanism, led by the NDRC and MOFCOM, organizes, coordinates, and guides the Security Review. According to the Measures, a party reporting a proposed foreign investment must submit to the Working Mechanism a declaration form, an investment plan, a statement on whether the foreign investment affects national security, and other materials requested by the Working Mechanism.

Within 15 working days of receiving the above from the relevant parties to a transaction directly or relayed by provincial level government authorities (which implies that the Working Mechanism and the decision-making process will be confined to the central NDRC level, similar to that of the anti-monopoly review mechanism conducted by the State Administration for Market Regulation), the Working Mechanism will decide, and notify the relevant parties, whether it will conduct Security Review of the proposed investment. If the decision is negative, the parties may proceed with the proposed investment, although if they modify the investment, and the modified investment is still subject to reporting for Security Review, the modified investment must be reported (and the process commenced) anew.

If, with the 15 working days, the Working Mechanism decides to conduct Security Review, it must complete a “general review” within the next 30 working days. After the general review, the Working Mechanism may notify the relevant parties that they may proceed with the proposed investment, or the Working Mechanism must complete a “special review” within the next 60 days (which, under “special circumstances”, may be extended (an unspecified amount of time)). After the special review, the Working Mechanism will permit the investment, prohibit it, or present conditions for the parties’ acceptance in order to proceed with the investment.

The timetable excludes any time taken by the parties to provide additional materials requested. The Measures also do not specify any criteria for the Working Mechanism’s determinations, except the criterion “whether or not the proposed investment may/will affect national security”, and no indication is given as to the potential nature of the conditions that may be imposed for proceeding with a proposed investment.

What Liability May Exist under the Measures

If parties carry out a foreign investment not in compliance with the Measures, e.g., failing to report an applicable investment before carrying it out, the Working Mechanism can impose a time limit for the parties to submit for review and, if they do not, can order the parties to dispose of equity or assets and to take any other action deemed necessary (by the Working Mechanism) to revert to the state of affairs before the investment was carried out (i.e., to unwind the transaction). This is the ultimate result also if the parties provide false information during Security Review or fail to fulfill conditions imposed for proceeding with an investment, although the Working Mechanism will first give the parties an opportunity to “correct” their errors.

All the above, however, appear to be tied to the extent to which an investment does in fact affect national security, so it should not be taken for granted that a party who has carried out a foreign investment not in compliance with the Measures will necessarily assume any or all such liability.  On the other hand, the Measures provide for other consequences as well, namely, a “bad credit” mark in China’s developing “national credit rating system” and the catch-all (unspecified) “other punishment implemented in accordance with relevant national regulations”.

Takeaways

While the Measures do grant the PRC government a powerful and legitimate legal weapon against any foreign investments that have genuine and apparent national security concerns, foreign investors investing in China without significant national security issues or who are otherwise not “important/key” market players in the PRC (e.g., non-dominant market players  who would not likely trigger PRC anti-monopoly concerns) should not have unreasonably high concerns until further policy releases indicate otherwise. 

The potential concern that even insignificant foreign investments into the PRC might have to be reported, or if not reported will be queried and subject to Security Review, may be premature, and ultimately turn out to be unrealistic. The Measures might rather be taken as a sign that Security Review will for the foreseeable future be a precision tool for narrowly targeted specific countermeasures or just a safety net at the central government level to capture significant foreign investments (e.g., some big deals, some less common deal structures, etc.). The best advice for foreign investors that do not find themselves in this category would therefore be to stay calm and keep busness on the right track, as well as staying well-informed of any further policy updates before 18 January 2021, when the Measures will enter into effect, and even thereafter.