China's circular progress


Alarm bells sounded in China's venture capital and private equity industry earlier this year, following the issuance of Circulars 11 and 29 by the State Administration of Foreign Exchange. The investment community's concern stemmed from their view that these laws were draconian restrictions on the use of offshore special purpose vehicles by PRC residents, according to legal experts.

However, much of the uncertainty was dispelled on November 1, when Chinese authorities adopted Circular 75 to replace the earlier circulars. Circular 75 ?clearly shows an attempt by SAFE to smooth over the difficulties that people had with the prior regulations,? says Andrew McGinty, a partner at the Beijing office of Lovells law firm.

Reactions to the new regulation have been a mixture of relief and continued wariness among investors and their advisors. However, many of the investors already active in China are embracing the new regulation and look forward to resuming investment activities – which had noticeably decreased upon the issuance of Circulars 11 and 29.

The key obstacle presented by the earlier rules was the requirement for PRC residents to obtain pre-approval from authorities before engaging in share swaps to transfer assets to offshore vehicles. This requirement had a widespread impact and effectively froze most investment activities this year, given that roughly 90 percent of the funds investing in China are domiciled outside of the country. Offshore domiciled vehicles are preferred due to the obstacles to adopting ?modern day, Silicon Valley-type?VC arrangements within the capital structure of a Chinese company, as well as difficulties in taking a China-domiciled company public, says Lawrence Sussman, a partner at the Beijing office of O'Melveny & Myers law firm.

Prior to Circulars 11 and 29, there was no reporting or approval process required for carrying out such asset inversions.?There was a complete open door, an unfettered channel for moving assets offshore,? according to Sussman.

The main improvement offered by Circular 75 over the previous circulars is the replacement of the pre-approval requirement with a registration regime for PRC residents seeking to transfer assets offshore. Those PRC residents wishing to transfer assets to offshore SPVs will still be subject to disclosure requirements, but these disclosures would be made at?acceptable levels,?says Sussman.

Overall, legal experts view Circular 75 as an improvement over the previous regulations.?Circular 75 provides much better guidance than Circulars 11 and 29. It is better documented, better drafted, and more workable,?says Lovells' McGinty. ?Many of the more onerous provisions in the previous drafts have been removed, and Circular 75 will probably represent a more stable position going forward.?

However, the new regulation still creates substantial liabilities for investors. Investors in Chinese companies domiciled in offshore jurisdictions must ensure that all shareholders in the companies adhere to Circular 75's registration requirements. Failure to comply with these rules could impede the investors' ability to pay dividends or other remittances, or even exit the company through an IPO, according to Sussman. He cautions,? Going forward, investors will need to put in place mechanisms – such as covenants and powers of attorney – to allocate risk and enforce compliance, otherwise one ?bad? minority shareholder could cause the target company to not be able to remit assets to China.?

Circular 75 also calls for retroactive compliance, which may impact some investors who – in the time between the issuance of the old rules and Circular 75 – circumvented the pre-approval requirement. These shortcuts typically involved not directly granting shares to PRC residents, instead holding those shares in trust vehicles until further clarification of the laws. Those investors engaging in such practices will have to ?come clean about why they did not follow the old circulars and show how they will retroactively comply with the new disclosure requirement,?says Sussman.

The reaction to Circular 75 has been ?full steam ahead,? particularly by ?old-timer? investors in China, says Sussman.?There are nuances and risks that lawyers would be critical of, but the VCs are relieved because they only had one objective: to remove the fundamental barrier presented by the pre-approval regime.?

?What the VC community ultimately wants is something practical and workable,?adds McGinty.

However, while established investors in China may be eager to jump back into the action, Circular 75 has caused skittishness among investors thinking to enter the market. ?For some strange reason, the Chinese government seems to be trying to create impediments to the external investment of dollars into China,? comments Leonard Harlan, co-founder of private equity firm Castle Harlan.?As a professional investor, this would lead me to rethink investing in China. I would hope that this would be something temporary, and that the future would bring a lessening of restrictions.?