On 3 February 2011, the China State Council published a Circular on Establishment of the Security Review System for Merger and Acquisition of Domestic Enterprises by Foreign Investors (State Council Circular) on guiding Merger and Acquisition (M&A) of domestic enterprises by foreign investors involving security review issues.
Following the issuance of the State Council Circular, an Interim Provisions on the Security Review Mechanism for the Merger and Acquisition of Domestic Enterprises by Foreign Investors (Interim MOFCOM Provisions)was published by the Ministry of Commerce (MOFCOM) in March 2011.
On 25 August 2011, MOFCOM released Provisions on the Security Review Mechanism for the Merger and Acquisition of Domestic Enterprises by Foreign Investors (MOFCOM Provisions) which is an operating rule in the State Council Circular, replacing the interim MOFCOM Provisions and coming into effect as of 1 September 2011.
These developments unveiled a new regime that established a potentially broad review process that will have a major impact on foreign investors that will be engaged in M & A activities in China.
Background
On 8 August 2006, MOFCOM issued the Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors (M&A Rules). The M&A Rules, for the first time, provides for notification and review of an inbound M&A transaction that might have an impact on China's “national economic security”.
Subsequent to the M&A Rules, the PRC Anti-Monopoly Law, released in 2008 further requires a “national security” review when a foreign investor participates in the concentration of business operations by merging or acquiring a domestic enterprise or by any other means where national security may arise. But neither the M&A Rules nor the PRC Anti-Monopoly Law provides any details on the matter other than mere reference to the term “national security.”
Altogether, the State Council Circular, MOFCOM Provisions, M&A Rules, and PRC Anti-Monopoly Law currently form the core of the national security review regime for foreign M&A activities in China. This article briefly examines some of the major issues involved in this newly-created regime with potential wide-ranging ramifications for foreign investors going forward.
Scope of Security Review
Industry subject to National Security Review
According to the State Council Circular, a national security review covers the following major industries: national defense industry, including industrial military enterprises and military-related industrial enterprises, enterprises located in close proximity of key and sensitive military facilities, and other entities which have an impact on national security; other sensitive industries, including important agricultural products, important energy and natural resources, important infrastructure, important transport services, key technology and major equipment manufacturing. Any acquisition of actual control of businesses in these sensitive industries will be subject to a security review.
Types of Foreign M & A Subject to Review
According to the State Council Circular, the M&A of domestic enterprises by foreign investors refers to the following four types of transactions:
(i) foreign investors purchase the equity interests of a Chinese enterprise or subscribe for increased capital of a Chinese enterprise;
(ii) foreign investors purchase the equity interests of a Chinese shareholder of a foreign-invested enterprise (FIE) in China or subscribe for increased capital of an FIE;
(iii) foreign investors set up an FIE and use it to purchase and operate the assets of a Chinese enterprise, or use the FIE to purchase the equity interests of a Chinese enterprise; and
(iv) foreign investors directly purchase the assets of a Chinese enterprise and establish an FIE based on such assets and operate the assets.
National Security Review Authorities
MOFCOM is the State authority responsible for preliminary review of potential transactions. If MOFCOM determines that a particular transaction is subject to a security review, it will forward the application for substantive review to an Inter-ministerial Committee, consisting of representatives of MOFCOM, the National Development and Reform Commission and other relevant departments depending on the specific industries of the potential transaction.
In reviewing a covered transaction, the Inter-ministerial Committee will consider the impact of the transaction on national defense, national economic stability, social order and research and development capabilities of major technologies affecting national security.
Security Review Process
In accordance with the State Council Circular, there are three ways to initiate the National Security Review:
Voluntary Filing - Any foreign investor involved in an M&A transaction which may potentially trigger a security review can voluntarily file an application for review with MOFCOM.
Review Requested by Third Parties - Concerned government departments, national industrial associations, competitors and upstream and downstream enterprises that believe a particular M&A transaction should be subject to a security review can submit a request to the Inter-ministerial Committee, through MOFCOM, for security review.
Ex Officio Review by MOFCOM - If a local branch of MOFCOM, during its review of an M&A transaction application, finds the M&A transaction subject to security review, such agency will require the foreign investor to file an application with MOFCOM.
Timeline for Review
MOFCOM is obligated to notify the applicant in writing within 15 working days after the receipt of the application documents and submit to the Inter-ministerial Committee for review and approval within 5 working days after the date of notification. The applicant cannot conduct the M&A transaction within the 15 working days after the date of notification. If the applicant does not get further written notice from MOFCOM within 15 working days after such date of notification, the applicant can proceed with the relevant formalities according to laws and regulations.
Anti-avoidance Provision-Substance Over Form
Under the State Council Circular, MOFCOM and the Inter-ministerial Committee will take a “Substance Over Form” approach in the national security review process which looks more closely at the substance and actual effect of an M&A transaction in China involving foreign investors rather than the forms it utilizes. Article 9 of the State Council Circular also expressly prohibits foreign investors from adopting any measures designed to avoid security review, including nominee shareholding(proxy) arrangements, trust arrangements, multi-layered reinvestment structures, leasing arrangements, loan arrangements, control agreements, offshore transactions and so on.
Impact on the VIE Structure
The anti-avoidance provision has wide ramifications for the variable-interest entity structure (VIE). The VIE structure has been used by many foreign investors to indirectly enter certain sectors in China without Chinese regulatory approval where foreign direct investment is restricted or prohibited. Under such arrangement, the Chinese founders of a domestic Chinese business and foreign investors invest in a new offshore holding company that owns a Chinese onshore subsidiary that is a “wholly-foreign owned enterprise” (WFOE) under PRC law. The WFOE enters into a series of contractual arrangements with the existing Chinese entity (the VIE) that is owned by the Chinese founders. This structure allows for the WFOE’s control of the VIE, the transfer of the economic benefits of the VIE to the WFOE, and offshore financing of the offshore holding company, or an offshore IPO.
Due to the anti-circumvention clause within the State Council Circular, such VIE structures are now subject to national security review.
Conclusion
The State Council Circular and the MOFCOM Provisions provides preliminary guidance on national security reviews for foreign investors aiming at M&A within China but remains silent on what constitutes “important,”“key” or “affect national security.” It is still unclear what types of minority investor rights constitute control, and how the Inter-Ministerial Committee will weigh different factors in its review in practise.
By Simon Bai, Winners Law Firm
WINNERS has been recognised consecutively as "Tianjin Firm of the Year" by two international legal journals: Asia Legal Business from 2008-2011, and by China Law & Practice from 2009-2011.
On 3 February 2011, the China State Council published a Circular on Establishment of the Security Review System for Merger and Acquisition of Domestic Enterprises by Foreign Investors (State Council Circular) on guiding Merger and Acquisition (M&A) of domestic enterprises by foreign investors involving security review issues.
Under the State Council Circular, MOFCOM and the Inter-ministerial Committee will take a “Substance Over Form” approach in the national security review process which looks more closely at the substance and actual effect of an M&A transaction in China involving foreign investors rather than the forms it utilizes. Article 9 of the State Council Circular also expressly prohibits foreign investors from adopting any measures designed to avoid security review, including nominee shareholding(proxy) arrangements, trust arrangements, multi-layered reinvestment structures, leasing arrangements, loan arrangements, control agreements, offshore transactions and so on.
