Exciting and uncertain times

The year 2006 has thus far been a remarkable one for the venture and private equity markets in China. On the one hand, during the first half of the year alone, the amount of venture investment and private equity in China more than doubled compared to the same period in 2005, indicating a robust market and steadfast interest on the part of foreign investors. On the other hand, the recent promulgation of several new laws and regulations by PRC authorities has created significant regulatory uncertainty for foreign investors.

The following article describes some of the issues faced by foreign investors who enter the Chinese market during this period of tremendous change.

Foreign Invested Enterprises
Although the PRC government promulgated the Foreign Invested Venture Investment Enterprise Administrative Regulations (the ?FIVIE? Regulations) in an effort to bring foreign venture capital and private equity firms into China, for a variety of reasons, in practice the use of an offshore holding company coupled with the establishment of a foreign-invested enterprise (?FIE?) remains the structure of choice for most private equity funds.

Setting up an offshore vehicle, typically in the Cayman Islands, British Virgin Islands, or other tax haven, takes as little as a few days.

In the PRC, setting up an FIE remains fairly straightforward, although the time involved in completing the establishment process has increased following recent regulatory changes, described in detail below. Types of FIEs include representative offices, equity joint ventures (?EJVs?), cooperative joint ventures (?CJVs?), and wholly foreignowned enterprises (?WFOEs?).

The most widely used vehicle by private equity investors is the WFOE. This may be due in part to the fact that while negotiating a joint venture contract to establish an EJV or CJV can take considerable time (depending on how long the parties take to work out all of the details of their agreement), and establishing a WFOE takes as little as a few weeks.

Due to a new requirement that FIE establishment documents be not only notarized but also authenticated, all FIEs take at least two weeks longer to set up now than they did prior to April 2006. The ?Implementing Rules on Certain Legal Issues Regarding the Approval and Registration Regulations of Foreign Invested Enterprises? (the ?New FIE Rules?) require all foreign companies that wish to establish an FIE to submit, along with other relevant application materials, a notarized and authenticated copy of the certificate of incorporation and/or business license of the offshore company, which involves securing a notarization and an apostille of the Articles (i.e. the Certificate of Incorporation) from the registrar of the company's respective offshore jurisdiction. The notarized and authenticated documents are then submitted to the Ministry of Commerce (?MOC? aka ?MOFCOM?) for further approval.

Regulatory changes have meant not only additional authorizations, approvals and other requirements, but may also lead to increased costs and more time being required to complete foreign investment transactions.

Navigating the new M&A regulation
Effective from September 8, 2006, MOFCOM, along with several other Chinese government agencies, issued new regulations for M&A transactions in China. These ?Administrative Measures for Strategic Investment by Foreign Investors in Listed Companies? (the ?2006 Regulations?) and the ?Provisions on the Mergers and Acquisitions of Domestic Enterprises by Foreign Investors? (the ?Revised M&A Provisions?) represent a significant departure from the Chinese government's traditional policy of containing foreign investors' ability to acquire shares listed on the Chinese stock markets. These regulations are of particular interest to foreign venture capital and private equity funds that intend to make further investments in China.

First, the Revised M&A Provisions, which replace the ?Interim Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors? (the ?Interim M&A Provisions,? issued in 2003), have introduced new layers of ambiguous and potentially onerous regulatory requirements that, at least in the short-term, will make it more challenging for foreign fund managers and their advisors to assess risk and to structure their investments in China. Although over time MOFCOM will no doubt clarify these regulatory ambiguities, either formally through the issuance of interpretative rules or informally through other means, for the time being, foreign private equity funds should be prepared to accept heightened regulatory uncertainty in connection with their China investments.

Second, the Revised M&A Provisions include the longanticipated ?share exchange? rules, which are designed to allow for the exchange of shares of domestic Chinese companies for shares of offshore companies. In addition, the Revised M&A Provisions also provide a mechanism for share exchanges with offshore special purpose vehicles (?SPVs?) where the SPV will become listed on an offshore stock exchange within one year.

The Revised M&A Provisions are not clear, however, on whether a share exchange will be available in the context of offshore restructurings that do not involve a stock exchange listing. To the extent the Revised M&A Provisions do not allow share exchanges in that context, they represent a disappointment to foreign venture finance and private equity investors. Such investors often restructure their onshore portfolio companies using offshore SPVs, which can be a cumbersome process under existing regulations that do not contemplate share exchanges.

Third, the Revised M&A Provisions, like the Interim M&A Provisions, require regulatory approvals for cross-border M&A activities by foreign investors, including the acquisition by foreign investors of the equity or assets of a domestic Chinese company. In addition, the Revised M&A Provisions create new layers of regulatory approvals that affect offshore SPVs and that may impact the ability of foreign investors and their Chinese counterparts to structure in-bound venture and private equity investments going forward.

Fourth, although MOFCOM review is required whenever a foreign party acquires a domestic Chinese company in a ?key industry,? where the acquisition may influence ?national economic security? or result in the transfer of a famous trademark or ?time honored brand,? each of these vague concepts are, remarkably, left undefined in the regulations, and thus are wholly subject to the discretion of MOFCOM.

MOFCOM approval is therefore required for the vast majority of private equity and venture financings involving offshore restructurings. The Revised M&A Provisions are sufficiently vague that they leave ample administrative discretion to MOFCOM. Furthermore, if an M&A transaction is completed without the required MOFCOM review and approval, the Revised M&A Provisions authorize MOFCOM to either rescind the M&A transaction or retroactively amend the agreed contractual terms and conditions of the M&A transaction.

The Revised M&A Provisions set out detailed approval requirements for acquisitions and for share exchanges. Once the application documents have been submitted, MOFCOM will review the application and render a decision within thirty days. If approved, MOFCOM will issue a ?Certificate of Approval? for the transaction that is effective for a period of up to eight months. The Revised M&A Provisions also require applicants using an offshore SPV to file an overseas investment registration form with the local department of the State Administration of Foreign Exchange (?SAFE?).

For financing structures in which the offshore entity does not directly invest in the domestic Chinese company, but instead forms a WFOE which then enters into a series of captive company contracts with the domestic Chinese company (also known as ?Sina contracts? creating a structure referred to as the ?Sina-structure? ), the analysis under the Revised M&A Provisions is unclear. The Revised M&A Provisions do not directly address a transaction where there is no ?direct? acquisition of shares or assets of a domestic Chinese company. We believe that MOFCOM intends to view this kind of structure as an acquisition for purposes of the Revised M&A Provisions, and thus will require that approval be obtained prior to establishing the offshore holding company.

Further difficulties for internet and telecom companies
On July 13, 2006, the Ministry of Information Industry of the People's Republic of China (?MII?) issued a new notice concerning foreign-invested telecom and internet companies in China. MII's ?Notice on Strengthening Regulation of Foreign Investment in and Operations of Value-Added Telecom Services? (the ?MII Circular?), further clarifies the existing regulatory framework governing foreign investment in internet and other value-added telecommunications (?VATS?) businesses in China. Specifi-cally, the MII Circular amplifies certain principles set forth in the ?Administration Regulations on Foreign-invested Telecom Enterprises?; Order of State Council No. 333 (the ?Revised Telecom Regulations?), issued on December 11, 2001 and effective on January 1, 2002. This is a particularly alarming circular because it calls into question the Sinastructure to create a legal structure of contractual relationships typically used in venture financings in China's VATS industry and other restricted industries where foreign investors are prohibited from owning a majority controlling stake in the PRC target company.

Going forward
How the Revised M&A Provisions will be interpreted and enforced by MOFCOM remains to be seen. We except that the effects of the Revised M&A Provisions on cross-border mergers and acquisitions, including private equity fi-nancing deals, will become clearer during the upcoming months, either through the issuance of formal interpretative rules by MOFCOM or through more informal discussions with MOFCOM in connection with ongoing and future M&A and financing transactions. We also note that MII may continue to require more stringent regulatory requirements for internet and telecom companies.

Rocky Lee is Head of Venture Capital & Private Equity Practice, China, for DLA Piper UK LLP's Beijing Office. Rocky. Lee@DLApiper.com