It’s been nearly two months since China’s new Foreign Investment Law (FIL) took effect, bringing sweeping revisions that ostensibly make China more hospitable to foreign investors. But has anything really changed? Or is the new law just window dressing?
The coronavirus outbreak has provided a convenient (and unassailable) rationale for anything that is or isn’t happening in China, and it may be months before we get a clear answer. But even before the coronavirus took center stage, the new law felt like a soft opening. The FIL is basic legislation on foreign investment and does not provide detailed guidance for foreign investors. Yes, China’s State Council issued Implementation Regulations and the Supreme People’s Court issued judicial interpretations regarding the FIL, but both were scant on concrete details.
Still, existing foreign invested enterprises (FIEs) and foreign entities planning new investments in China should at least understand what the law purports to do. We have outlined below some of the most notable changes, and how (or if) foreign investors will be affected.
One of the FIL’s key precepts is national treatment; under the FIL, China will implement a “pre-establishment national treatment and negative list” system. “Pre-establishment national treatment” means that foreign investors will be treated no less favorably than Chinese investors at the “entrance stage,” so long as the invested industry is not on the negative list. Thus far, China has not defined the term “entrance stage,” but it likely means the period before an entity has received a business license, when (for instance) it is applying for permits and/or providing evidence of qualifications that must be approved before the entity can operate in a regulated industry.
The Implementation Regulations provide that government agencies shall not discriminate against foreign investors regarding required permits or licenses unless laws or regulations provide otherwise. Unless laws or regulations provide otherwise – an exception big enough to swallow the entire provision! In many industries, foreign investors are not outright prohibited by the negative list, but receive quite different treatment. For example, foreign investment in construction of commercial airports requires pre-establishment permits as well as compliance with various Civil Aviation Administration rules. Does the passage of the FIL require these strictures to be repealed or changed? Or will they continue to exist in the same form as before?
National treatment is one of those phrases that sound good but is meaningless without context. Under the FIL, “national treatment” does not mean any changes will be made to the negative list, nor that discriminatory rules will be repealed in industries that aren’t on the negative list. It just means Chinese government agencies cannot officially discriminate against foreign-owned entities because they are foreign-owned. But Chinese agencies are masterful at unofficial discrimination, as any foreign entity that has tried to get an arbitral award enforced in China can attest. Without meaningful instructions and followup from the national government, nothing will change and many of the attractive sectors will remain closed or highly restrictive to foreign investment.
Enforcement of Government Contracts
Over the years, numerous Chinese government entities (usually local municipalities) have promised foreign investors preferential treatment, only to renege or renegotiate after a leadership change or government reorganization. Article 25 of the FIL explicitly requires local governments and government agencies to honor all contracts legally entered into with foreign investors and FIEs, and provides that if changes in circumstances cause the local government to breach a contract, the government shall compensate foreign investors and FIEs their damages. Right. We look forward to the first lawsuit filed under this provision.
Changes in Corporate Governance
On Jan. 1, 2020, when the FIL came into effect, a set of laws and regulations that specifically applied to FIEs (WFOEs, equity joint ventures and contract joint ventures) were repealed en masse. Now FIEs are only subject to China’s Company Law, Partnership Law and the other laws that regulate business organizations. Under the FIL, a business entity’s corporate governance depends on its form (i.e., whether it is a corporation, LLC, or partnership), not whether it is foreign- or Chinese-invested.
The FIL provides a 5-year grace period for FIEs whose corporate governance is inconsistent with the Company Law, Partnership Law or other business organization laws to come into compliance. This grace period is most applicable to JVs; those not formed as a separate legal person may need to reorganize as a company or partnership; and all will need to change to shareholder governance. JVs will also be able to retain some flexibility after the 5-year period. For example, after a JV reorganizes, any agreement regarding ownership or its transfer, allocation and distribution of profit and losses, and distribution of assets after liquidation may remain effective.
Validity of Contracts
According to the Supreme People’s Court judicial interpretation on the FIL, a court should not nullify a contract regarding a sector not on the negative list because of lack of approval or registration, but should nullify a contract regarding a sector on the negative list. That said, Investment contracts regarding sectors on the negative list can still become effective if the parties take necessary corrective measures (i.e., revising so that the contract no longer relates to a sector on the negative list) before courts adjudicate the case. Finally, if a contract concerned a sector on the negative list, such contract can still be effective if such restriction is removed before a court issues a decision.
Putting the concept of “national treatment” front and center in the FIL is a positive sign, but it doesn’t seem to have much follow through yet. Non-Chinese companies investing in China face far more restrictions than do Chinese companies investing in countries outside China. The list of industries on the negative list still contains a number of attractive, popular sectors. And the FIL hasn’t even addressed the issue of foreign ownership of Chinese companies. For instance:
- What will happen if a foreign company wants to purchase 10% of the ownership interest of a private Chinese company?
- What will happen if a private or public Chinese company wants to issue stock options to foreign national employees?
- What is the legal basis for prohibiting the foreign purchase of stocks on the Shanghai/Shenzhen exchanges?
In part, the FIL is an attempt to clean up legislative clutter – both by removing the laws specifically regarding WFOEs and JVs and by specifically superseding previous legislation regarding foreign investment. From that standpoint, the FIL is a welcome and long-overdue piece of legislation. But it’s far too early to tell whether the FIL will provide meaningful changes (let alone opportunities) for FIEs in China.