E-ALERT China Practice

Transcription

1 E-ALERT China Practice February 18, 2011 CHINA ISSUES NATIONAL SECURITY REVIEW RULES FOR FOREIGN INVESTMENT China has established a new process for reviewing the national security implications of foreign investments in Chinese companies. On February 12, 2011, China s State Council published the Notice of the General Office of the State Council on Establishment of a Security Review System for the Merger and Acquisition of Domestic Enterprises by Foreign Investors (the Security Review Notice ; click here to link to the translation). The establishment of the procedures described in the Security Review Notice represents China s first formal step towards implementation of Article 31 of the Anti-Monopoly Law ( AML ), which provides that, in addition to anti-monopoly review, proposed investments in or acquisitions of Chinese companies by foreign companies which concern national security will be subject to review. The Security Review Notice will enter into effect on March 5, We expect that much commentary on the Security Review Notice will focus on the extent to which the China review process is similar to, or distinct from, the more well-known U.S. government national security review process that is administered by the Committee on Foreign Investment in the United States ( CFIUS ). While this inclination to compare the Chinese process to the one undertaken in the United States is understandable given the prominence of CFIUS as a national security-based screening mechanism, such a comparison is, at this stage, too narrow and premature. First, China is not alone in taking action to develop national security-based screening processes. Germany, Russia, Canada, and Australia, among others, each have considered or taken action in recent years that was directed at developing a national security or national interest-based review process for certain types of foreign investment, and there have been recent proposals to develop a foreign investment screening board for the EU. The proposed China process, therefore, should not be viewed solely by comparison to the U.S. process, but rather with an eye to assessing how it will fit with and compare to global approaches to reviewing foreign investment. Second, the actual rules that will govern the China process have not been finalized. At a press conference held in Beijing on February 17, 2011, a Ministry of Commerce ( MOFCOM ) spokesperson confirmed that detailed rules for implementation of the Notice are currently being drafted. Such rules may address the issues discussed below and provide further explanation and detail regarding China s new national security review process. Until those rules are finalized, it would be premature to reach any definitive conclusions of how the China process will impact foreign investment. Indeed, while furnishing some basic parameters and describing the security review structure for foreign investors proposed investments in or acquisitions of PRC domestic enterprises in circumstances where China s national security interests are implicated, the scope of many of the Security Review Notice s provisions is unclear. In particular, the Notice does not define with specificity the types of enterprises and products that would involve national security and thus deserve scrutiny. It also does not clearly address what constitutes actual control by a foreign investor, and it lacks clear timeframes and linkages with other elements of China s foreign BEIJING BRUSSELS LONDON NEW YORK SAN DIEGO SAN FRANCISCO SILICON VALLEY WASHINGTON

2 investment regime. These are important issues that will bear monitoring as MOFCOM works on the detailed implementing rules. In all events, companies considering investments from the acquisition of a minority interest to a full merger transaction with domestic PRC entities that operate in the sectors identified in the Security Review Notice should be aware of the developing process in China. And, as the rules come into force over the coming months, such companies will wish to carefully assess the effect the rules will have on their transactions, including whether security review filings will be required. With this introduction, the following provides a more detailed summary of the Security Review Notice provisions. Sectors Stated to Involve National Security The Security Review Notice provides that proposed mergers and acquisitions by foreign investors of the following types of domestic enterprises, in cases in which the foreign investor may obtain actual control of a domestic enterprise (see below), will be subject to the new security review procedures: (1) military and military support enterprises; (2) enterprises in the vicinity of key and/or sensitive military facilities; (3) other entities associated with national defense and security; and (4) domestic enterprises engaged in sectors that relate to national security : (i) important agricultural products; (ii) important energy and resources; (iii) important infrastructure; (iv) important transportation services; (v) key technologies; and (vi) major equipment manufacturing industries (See Security Review Notice Clause I (1) (translation by Covington & Burling LLP)). The terms important and key are not defined. Moreover, limited guidance exists in other published PRC rules and regulations as to what is considered important or key. 1 Absent further elaboration from the Chinese government, the scope of this provision is uncertain and potentially very broad. It is also worth noting that some of the sectors stated to be potentially sensitive - such as agricultural products - involve products and sectors with respect to which foreign investment is 1 A limited precedent exists in certain previous PRC administrative documents discussing major equipment manufacturing industries. These documents, which include a circular issued by the State Council in 2006 and a catalogue issued by the Ministry of Industry and Information Technology, Ministry of Technology, Ministry of Finance and State-owned Assets Supervision and Administration Commission in 2009, provided, by way of example, that large-scale clean and efficient power generation equipment, large-scale construction and engineering equipment, civil aircraft, and high-technology equipment used in the electronics, biological and pharmaceutical industries are deemed major equipment. 2

3 encouraged under China s Foreign Investment Guidance Catalogue (the Catalogue ). 2 It is unclear how, or whether, the sectors identified in the Security Review Notice will be interpreted to align with those encouraged under the Catalogue so that China will not by virtue of the new rules in effect re-characterize investments that would heretofore have been encouraged as now being discouraged due to national security considerations. Definition of Actual Control Actual control as defined in the Security Review Notice appears to be broad enough to include not only scenarios in which foreign investors hold majority equity interests in Chinese companies but also those in which foreign investors hold only minority interests but have the right to exercise material influence or otherwise exercise control over certain corporate decisions of their investees. According to the Notice, a foreign investor will be deemed to have gained actual control of a PRC domestic entity and thus may be required to file an application for security review in the following circumstances: (a) a foreign investor and its controlling parent company and controlled subsidiaries hold 50% or more of the enterprise s equity in aggregate following the merger or acquisition; (b) several foreign investors, in aggregate, hold 50% or more of the enterprise s total equity following the merger or acquisition; (c) the foreign investor holds less than 50% of the enterprise s equity in aggregate after the merger or acquisition, but the voting rights to which it is entitled based on the shares it holds are sufficient to give it material influence with regard to the resolutions adopted at shareholders meetings, general shareholders meetings or board of directors meetings of the enterprise; and (d) other circumstances that result in the transfer to a foreign investor of actual control of matters such as operational decisions, finance, personnel and technology of a domestic enterprise. (Security Review Notice Clause I (3)) Sub-clauses (c) and (d) of this definition can be read to cover a broad array of investment scenarios. Because the concept of material influence is not defined, it is not clear how extensive a foreign investor s involvement in the operation of the Chinese company, or its influence at shareholder or board meetings, must be before that investor may be deemed to have acquired actual control over the Chinese company. For example, it is common as a matter of corporate governance even in the case of Chinese ventures and enterprises in which foreign investors hold a minority of the equity for decisions relating to important matters to require a super-majority, or even unanimous, vote. Foreign investors, even if they are only minority shareholders, also often wish to have the right to appoint the managers of key corporate departments within their Chinese investee entities, such as finance, human resources and technical operations. 3 In light of the uncertain scope of this provision, prospective investors should consult with counsel to determine whether the post-closing 2 The Catalogue is a key policy document comprising part of China s foreign investment framework that is updated by MOFCOM and the National Development and Reform Commission ( NDRC ) from time to time to provide guidance to foreign companies wishing to invest in China. The Catalogue categorizes various industry sectors as encouraged, restricted or prohibited for foreign investment. All other industries are deemed permitted. 3 In this regard, it is interesting to note that in a February 17, 2011 NDRC Q&A on the Security Review Notice, the NDRC response to a question as to what sorts of transactions require security review included the following statement: The Notice has defined the meaning of actual control, and we believe that general investment by means of minority equity participation does not entail the transfer of actual control. 3

4 corporate governance structure they are considering as part of their investment may raise national security concerns in China, and whether a security review filing might be required. Scope of Review National security reviews of transactions that are deemed to be subject to the review process will assess the transaction s impact on: (1) national defense and security, including its impact on the production capacity of defenserelated domestic products, capacity of provision of defense-related domestic services, and equipment and facilities that are required for national defense; (2) national economic stability; (3) the basic order of life in society; and (4) research and development capabilities related to key technologies associated with national security. (See Security Review Notice Clause II) Sub-clauses (2) and (3) establish a scope of review that is broader than the CFIUS review in the US and comparable reviews in other countries. The Notice also leaves the terms national economic stability and basic order of life in society undefined. Accordingly, the reach of these provisions is not clear. Foreign companies considering investments in or acquisitions of Chinese domestic enterprises even enterprises that are in conventionally non-sensitive sectors should evaluate carefully whether these provisions might apply. Reviewing Agencies and Procedures Pursuant to the Security Review Notice, an inter-ministerial panel ( Ministerial Panel ) will be established under the State Council, with NDRC and MOFCOM taking the lead in coordinating with other relevant ministries and agencies to review proposed transactions that are subject to the new security review procedures. Unlike CFIUS in the US, the Ministerial Panel is not an administrative body. MOFCOM is designated as the agency that will receive applications for security reviews and notify foreign investors of final decisions. Different ministries and agencies may be called upon to join the review process, depending on the sector in which a proposed transaction is taking place. It is unknown which MOFCOM department will handle the applications (although according to the MOFCOM spokesperson at the February 17 press conference, it is MOFCOM s Foreign Investment Department that is drafting the implementing rules referred to above). Perhaps it will be the existing Anti-Monopoly Office; or conceivably a new department will be set up to process security reviews. More importantly, the manner in which the national security review will interact with MOFCOM s filing and review procedures under the AML has yet to be explained. The Security Review Notice provides that foreign investors are required to file security review applications with MOFCOM, but provides no guidance as to when in the course of a transaction an application should be made, and what application documents will be required. The Notice also does not specify whether there are any consequences for failure to file. However, the Notice does provide that the Ministerial Panel can initiate security reviews based either on its own initiative after receiving the required notice, or in response to proposals made to MOFCOM by government agencies, trade associations or companies in the subject industry, or upstream or downstream sectors in that industry. See Security Review Notice Clause IV(2). The Notice appears to provide for the unwinding of consummated transactions that have already produced or may 4

5 produce a significant impact on national security.... See Security Review Notice Clause IV(6). Thus, government agencies and interested third parties such as competitors, suppliers, or customers may be able to seek to prevent or undo a transaction by proposing a security review at any time, perhaps including after the transaction has closed. The decision whether to open such an investigation, however, rests with the Ministerial Panel. If a transaction is found to have, or potentially have, a significant impact on national security, the Ministerial Panel can request MOFCOM to terminate the transaction, require a transfer back of the purchased equity interests or assets, or require the taking of other measures to eliminate such impact. Under the wording of the Notice, it appears that there is no mechanism for parties to a transaction to consult with MOFCOM or other agencies, formally or informally, to determine whether they have to file an application. Absent such a mechanism, a foreign investor that wishes to proceed with a transaction without making a security review filing will have to undertake a careful evaluation of the risk of a the transaction being reviewed post-closing and potentially challenged on national security grounds by the Ministerial Panel, acting either on its own initiative or in response to a request for a review from an interested third party. The Security Review Notice establishes various time limits for each step of review. Within five (5) business days after receipt of an application, MOFCOM will forward it to the Ministerial Panel, which will start a written consultation process within another five (5) business days with relevant ministries and agencies. All relevant ministries and agencies are required to provide written feedback to the Ministerial Panel within twenty (20) business days following initiation of the consultation process. If any ministry or agency being consulted is of the view that a proposed transaction concerns national security, a special review process will commence. Thus it appears that any one ministry or agency will be able to delay and potentially block a foreign takeover. The Ministerial Panel has sixty (60) days in which to complete a special review. If the ministries and agencies being consulted cannot reach consensus, then the State Council will make the final decision a process for which no time limit is specified. Conclusion The promulgation of the Security Review Notice is another step forward in the Chinese government s effort to enhance transparency and to formalize the procedures for the national security reviews that are to be carried out in addition to AML reviews for certain types of transactions. However, given the present lack of clarity and detail regarding the nature of the transactions requiring security review and the procedures and standards that will be applied during the review process, foreign investors involved in a wide range of industry sectors will need to proceed cautiously. In managing these uncertainties, a foreign investor contemplating a merger with, acquisition of, or investment in a Chinese company should assess carefully whether the transaction might require, or later trigger, a national security review, and also evaluate the possible risk that interested third parties may seek to encourage such a review. If in the final analysis the PRC authorities identify a national security concern, the foreign investor will have to consult with counsel to identify possible alternative structures that can both address such concern and meet their commercial objectives in China. 5

6 If you have any questions concerning the material discussed in this client alert, please contact the following members of our firm: Ellen Eliasoph (Beijing) Tim Stratford (Beijing) Mark Plotkin (Washington, DC) David Fagan (Washington, DC) James O'Connell (Washington, DC) This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the subjects mentioned herein. Covington & Burling LLP, an international law firm, provides corporate, litigation and regulatory expertise to enable clients to achieve their goals. This communication is intended to bring relevant developments to our clients and other interested colleagues. Please send an to if you do not wish to receive future s or electronic alerts Covington & Burling LLP, 2301 Tower C Yintai Centre, 2 Jianguomenwai Avenue, Chaoyang Dist., Beijing All rights reserved. 6