In January, China’s Ministry of Commerce (MOFCOM) released a draft of a new foreign investment law that had private equity sponsors worldwide standing at attention. If approved, the new law promises to dramatically change the regulatory regime for foreign investment in China, and mostly for the better.
Most importantly for the private equity world, the law is expected to facilitate foreign investment in Chinese companies by removing the existing case-by-case approval process for every transaction conducted by a foreign investor. The relief would put foreign private equity firms on more equal footing with their domestic PRC competitors.
“The draft law, if passed, will have far-reaching effects on the private equity industry,” Peng Yu, a Hong-Kong-based lawyer for Ropes & Gray told pfm.
There’s just one catch: there is no definite timetable for the draft law. It is expected that MOFCOM is in the process of coordinating with other PRC governmental agencies and trying to form an aligned position, which means changes to the current law are expected.
“It would not be surprising if the draft eventually submitted to the State Council or China’s National People’s Congress will have certain substantive changes from the MOFCOM consultation draft on some of key issues,” Yu warned. The question now is how receptive regulators across China’s various state agencies will be to stakeholders’ comments.
What the proposals say
The draft regulation removes the lengthy approval process for each investment and replaces it with a “negative list” of restricted industries. Foreign investments in sectors that are not identified on the “negative list” will be able to proceed with corporate registration in the same way as domestic PRC investors would. The list has not yet been published, but it is expected to bear some resemblance to the existing foreign investment catalogue, which was just updated in April. Restricted or prohibited industries are likely to include internet, healthcare, education, infrastructure/energy and financial institutions, according to Yu.
While the overhaul removes the upfront approval requirements for each single foreign investment, investors will have more comprehensive reporting requirements. Those include reporting on deal closings and after certain changes within an investment, as well as periodic reporting for investors whose operations in China exceed defined thresholds.
“There have been critical views by commentators on the expansive scope of the reporting requirements,” said Yu. “Generally speaking, we do not expect this to be a major deterrent when foreign private equity funds formulate their investment strategy in China.”
While the existing regime determines whether an investor is foreign based on the place of incorporation of the investing vehicle, the new regulation introduces the concept of “control.” Under the current regime, a Cayman Islands company that wholly owned by a PRC national would still be regarded as “foreign.” The new law proposes that if the investment is ultimately controlled by PRC nationals, it will not be regarded as a foreign investment and not be subject to foreign investment restrictions.
Thus, investors may not need the controversial “variable interest entity” (a structure used to facilitate the offshore financing of PRC companies doing business in regulated sectors) in investments where PRC nationals maintain control, and foreign private equity investors will be able to hold equity in businesses rather than relying on contractual protection through VIE agreements.
After the MOFCOM consultation period expired in February and in March, the regulator indicated that they had received “overwhelming responses” from various stakeholders, Yu said.
“The general consensus reflected in the responses, as MOFCOM indicated, is that the draft law is positive and constructive in promoting foreign investments and creating a transparent regulatory regime,” said Yu. For private fund managers with an interest in China, the question now is: will regulators listen?