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China’s Legislature Enacts Its New Foreign Investment Law

by Richard Grams

 

After a month-long consultation period, China’s National People’s Congress today passed the country’s new Foreign Investment Law (the “FIL”). The FIL, which comes into effect on January 1, 2020, will abrogate substantial parts of the legal framework that has governed foreign investment in China for the past 40 years.

First introduced as a draft in 2015, the FIL became bogged down but late last year, an amended version was re-released and then fast-tracked for consultation, in an effort to placate concerns in the EU and the United States about unfair trade practices. In particular, China is accused of limiting market access, forcing technology transfer to Chinese partners and doing little to curb theft of intellectual property, all in violation of its WTO commitments.

The FIL clearly aims to address those concerns but it goes further, overhauling a divided system that regulates inbound investment separately from domestic businesses and which imposes significant restrictions on foreign-invested projects. That system will be unified and standardized.

We have summarised below the major details of the draft law for your reference.

 

Streamlining of Market Entry Procedures & National Treatment

China has been shifting away from an approval-based system to a reporting-based business supervision system since 2015. Foreign investors merely file information with a regulator when they incorporate and thereafter on a periodic basis. The FIL takes this a step further by invoking consistency between filing requirements of foreign-invested enterprises (“FIEs”) versus Chinese-invested businesses.

In late 2018, China’s National Development and Reform Commission implemented a “Negative List” approach like the one used in the Shanghai Pilot Free Trade Zone, permitting foreign investors to invest in any sector that does not appear on the negative list. This has been co-opted by the FIL.

The negative list prohibits foreign investment in some sectors, for national security reasons, while merely imposing restrictions on others. Non-Chinese investors seeking to invest in sectors categorized in the negative list as restricted must first apply to the Ministry of Commerce (“MOC”) for approval and may be subject to other restrictions as well, such as having to partner with a Chinese investor. However, once established, FIEs are meant to be free of arbitrary restrictions or conditions imposed by PRC government agencies (Article 24).  

The key take-away is that foreign investors in sectors that are not on the negative list will be free of all foreign investment restrictions and entitled to ‘national treatment’ in terms of how they are regulated which is no less favourable than what Chinese investors enjoy (Article 4).  In principle, this should level the playing field for both FIEs and domestic businesses in China in all respects including bidding for government procurement projects (Article 16) and obtaining equity or debt financing (Article 17). Article 8 is a grim reminder that a level playing field also means compliance with unwelcome laws and policies.

 

Protection of Foreign Investment & Intellectual Property 

  • The FIL contains several provisions aimed at promoting foreign investment in China and protecting foreign interests in those investments, including those:
  • affording greater protection to commercial secrets and other intellectual property rights (“IPRs”) of foreign investors and FIEs that rely on those IPRs (Article 22)
  • respecting commercial agreements reached between foreign investors and Chinese partners (Article 22). All pre-existing laws and regulations placing limits on or requiring parties to restructure their commercial agreements are to be repealed (Article 24)
  • abolishing mandatory technology transfers by governmental officials and repeal of all pre-existing laws and regulations in China used to force such technology transfers (Article 22)

 

Variable Interest Entities (“VIEs”)

The FIL extends China’s existing foreign investment regime to include foreign-controlled entities, where “control” is broadly defined and includes contractual control (Article 2). This reverses the currently-ambiguous legal status of VIEs which Chinese regulators have tacitly permitted for many years.

Taking advantage of a legal loophole, foreign investors seeking access to restricted sectors have frequently used VIEs in the past, using contractual arrangements between their FIEs and Chinese companies, to facilitate foreign investment where investment would otherwise be prohibited or restricted.

The FIL closes the loophole by explicitly designating VIEs as FIEs, subjecting them to regulatory control which is likely to restrict formation of future VIE-type arrangements (Article 28) and may result in existing VIEs having to be unwound (Article 36).

 

National Security Review Process

Although the FIL only briefly touches on China’s Anti-Monopoly Law and national security review regime processes, the fact that these are mentioned at all implies that they may exert greater influence in regulating foreign investments in the future. The national security review regime, similar to CFIUS in the United States, currently applies to any foreign acquisition or merger deemed “sensitive”Investors then decide whether or not to voluntarily seek a formal review or wait to respond to demands for one by regulators.

Article 35, when read together with Article 6 and Article 40, appears to widen this scope for national security reviews. Our assessment is as follows:

  • additional rules and structures will likely be added to the existing national security review criteria, through separate implementing legislation, to prohibit foreign investment in key businesses or sectors to avoid “harming the public interest” (Article 6)
  • among the factors considered in any national security review of any proposed foreign investment will be the anticipated economic impact on domestic PRC businesses
  • foreign investment deemed too sensitive will either not be approved or only approved subject to market entry restrictions
  • the FIL prohibits appeals from unfavorable national security review decisions (Article 35).

 

Criticisms

Although it is tempting to dismiss the FIL as mere window-dressing meant to appease trade officials in the United States and EU, its impact on foreign investors and FIEs over the medium and long-term is likely to be significant. Expect to see regulators redoubling efforts to crack down on theft of IPRs and a sudden influx of global market leaders, in sectors like financial services and civil aviation, as those gates are opened. The simplification of corporate governance requirements will likely

Nevertheless, it’s important to not lose sight of the FIL’s deep flaws; most its provisions are vaguely worded and despite the high-minded statements of principle concerning fair and equal treatment, discrimination against foreign investors and FIEs lies at the very heart of the FIL and China’s foreign investment legal framework as a whole. Most worrying are Articles 6 and 40 which hint at the politicization of China’s national security review regime and its use to keep foreign competition out of consecrated sectors. Hence, foreign investors should not be surprised if they still encounter barriers to entry, or if they remain subjected to unfair disadvantages when bidding for government contracts.

Whether or not the FIL noticeably improves conditions for foreign businesses depends almost entirely on how faithfully the FIL and its implementing regulations are enforced at the local level.

 

Final Comments

The FIL will not come into force until January 1, 2020. Until then, all inbound investments into China will continue to be governed by China’s current foreign investment regime which has already been slightly liberalised with the revised negative list already in effect. Investors planning to establish new businesses in China, particularly in sectors listed in the Negative List, would be better off waiting until after January 2020, when current market entry approvals and restrictions on corporate governance are lifted.

In the meantime, we will continue to closely monitor all new developments in relation to the FIL and issue updates on how foreign investors will be affected.

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