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China Establishes Mechanism for National Security Reviews of Foreign Investments

February 16, 2011

 

On February 3, 2011, the General Office of the State Council released long-anticipated rules for reviewing foreign direct investments in China for national security concerns. The new procedures, effective March 5, 2011, are set forth in the Notice of the General Office of the State Council on Establishing the Security Review Mechanism for Merger with and Acquisition of Domestic Enterprise by Foreign Investors (the Notice) [1]. On February 16, 2011, the National Development and Reform Commission (NDRC) posted informal guidance indicating that foreign investors will not be required to make a separate filing to initiate a security review; rather, the parties may be asked to provide information necessary for the security review in the course of other regulatory reviews[2].

While foreign direct investment projects in China have long faced a gauntlet of review and approval procedures by various government authorities, the Notice establishes the first detailed review mechanism devoted to national security issues. Several procedural and substantive facets of the new process resemble analogous procedures in the United States and elsewhere for screening foreign investment on national security grounds. Nevertheless, the Notice incorporates distinctive and broad standards, leaving unanswered many questions about the scope and impact of the new national security reviews.

Key Points

Here are five key points about the new review mechanism:

  • The Notice covers two basic categories of transactions: (1) Investments involving Chinese enterprises directly involved in the national defense industry, and businesses located “adjacent” to such enterprises; and (2) investments involving any other Chinese enterprise that more indirectly invokes national security concerns, such as critical infrastructure, “key” technologies, and “important” agricultural or energy products. Notably, the rules do not apply to transactions involving financial institutions or certain transactions involving “state-owned assets.”
  • Although the text of the Notice is not clear, the NRDC guidance clarified that with respect to either category of covered transaction, a “merger or acquisition” is reviewable only if the foreign investor will gain “actual control” of the enterprise. The Notice describes various scenarios by which such control may be acquired. The overall structure reflects an analytical approach quite similar to that followed by the Committee on Foreign Investment in the United States (CFIUS), but a number of questions concerning treatment of minority investments, for example, remain unanswered.
  • Reviews will be conducted by an interagency committee co-chaired by the NDRC and the Ministry of Commerce (MOFCOM). The committee will follow a two-step review process that also mimics the CFIUS process, including following a timeline that aims to complete reviews in about 90 days.
  • Importantly, covered transactions will be reviewed not only for their potential impact on national security, but also with respect to potential impacts on China’s “economic stability” and “social order.”
  • The interaction between the general foreign direct investment approval procedures and the national security review process remains uncertain. In recent years, provincial and local authorities have received greater authority to approve larger projects in more industries without central government involvement. The new national security review system channels certain transactions to the central government for review.

Legislative Background

National security concerns have long colored the Chinese government’s view of foreign investments, but the first measures providing for separate review of foreign direct investment on national security grounds appeared in the 2006 Rules for M&A of Domestic Enterprise by Foreign Investors (2006 M&A Rules)[3]. These rules introduced requirements for foreign acquisitions of Chinese firms that “result in actual control by the foreign investor” and “involve key industries, have factors imposing or possibly imposing material impact on the economic security of the State, or would result in transfer of actual control in a domestic enterprise which owns any well-known trademarks or Chinese historical brands”[4]. MOFCOM, “together with other relevant departments,” may act to block, modify or unwind unreported transactions with actual or potential “material impact” on the “economic security of the State.” The 2006 M&A Rules did not list "key economic sectors," define "national economic security,” or prescribe detailed procedures.

In practice, few parties have formally notified transactions for review pursuant to the 2006 M&A Rules, and MOFCOM has not publicly invoked these provisions to block any investments. Nevertheless, it was widely understood that Carlyle Group’s proposed acquisition of Xuzhou Machinery and certain other transactions foundered on issues spotlighted in the 2006 M&A Rules[5].

National security concerns resurfaced in the Antimonopoly Law (AML), China’s principal antitrust statute[6]. The (AML), which became effective on August 1, 2008, severs the review of mergers, acquisitions, and other concentrations on competition grounds from the review of investments on national security grounds. AML Article 31 provides that where a foreign investor merges with or acquires an enterprise within China or where any other form of concentration “concerns national security,” the transaction will be subject to separate review on national security grounds “in accordance with relevant regulations of the State.” This bifurcation was consciously modeled on the U.S. practice of separating antitrust reviews from national security reviews conducted by CFIUS[7]. The AML did not, however, prescribe specific procedures or standards for review.

On August 21, 2008, the NDRC announced plans to form an interagency committee to review the national security effects of foreign acquisitions of Chinese companies, but provided few details about the plans[8]. In June 2010, NDRC, MOFCOM and the Legal Office of the State Council circulated draft regulations entitled The Security Review System for Merger & Acquisition of Domestic Enterprises by Foreign Investors to domestic and foreign companies and trade associations for comment. The new Notice derives substantially from those draft measures.

Summary of Key Provisions

Scope of Covered Transactions

The Notice defines two categories of transactions that are subject to national security review:

(i) “mergers and acquisitions by foreign investors of any domestic defense industry enterprise or any defense industry supporting enterprise, any enterprise adjacent to key or sensitive military facilities, or any other enterprise related to national defense or security”[9]; and

(ii) “mergers and acquisitions by foreign investors of any domestic enterprise engaging in important agriculture products, important energy and resource products, critical infrastructure, critical transportation systems, key technology or equipment, in each case involving national security; provided that the actual control of the domestic enterprise is acquired by foreign investors after the transaction”[10].

As noted above, NRDC officials have clarified that the proviso in category (ii) - “provided that the actual control of the domestic enterprise is acquired by foreign investors after the transaction” - also applies to transactions described in category (i).

Both categories involve “mergers and acquisitions of domestic enterprises by foreign investors.” Such transactions are defined by reference to the concept of a Foreign Invested Enterprise (FIE), and encompasses the following four scenarios involving the formation or change in ownership of an FIE:

(i) “Foreign investors purchase shares from a domestic non-FIE, or subscribe for any capital increase of a domestic non-FIE, and after the transaction the status of the domestic enterprise is changed into an FIE.

(ii) Foreign investors purchase shares from a Chinese shareholder of an existing FIE, or subscribe for any capital increase of an existing FIE.

(iii) Foreign investors establish an FIE, and use that FIE to (a) purchase assets of a domestic enterprise and operate such assets after the purchase or (b) purchase shares of a domestic enterprise[11].

(iv) Foreign investors purchase assets directly from a domestic enterprise, and then establish an FIE to hold and operate such assets”[12].

The 2006 M&A Rules did not specifically address the types of transactions described in items (ii) and (iii) (to the extent (iii) covers the use of existing FIEs to acquire shares or assets of domestic enterprises).

The Notice defines the acquisition of “actual control” as “a merger or acquisition after which a foreign investor becomes the controlling shareholder or the actual controller of a domestic enterprise.” Such control may result from the following circumstances:

(i) “A foreign investor, its share-controlling parent companies, and share-controlling subsidiaries, collectively hold more than 50% of the total outstanding shares of the target enterprise after the transaction.

(ii) Several foreign investors collectively hold more than 50% of the total outstanding shares of the target enterprise after the transaction.

(iii) Although a foreign investor holds less than 50% of the total outstanding shares after the transaction, the foreign investor, through the voting power of such shares, may nevertheless materially influence the outcomes of shareholder meetings, general meetings or board meetings of the target enterprise.

(iv) Any other circumstances in which the actual control of business operations, finance, personnel and technology decisions of a domestic enterprise is transferred to a foreign investor”[13].

Importantly, the Notice specifies that mergers and acquisitions of domestic enterprises by investors from Hong Kong, Macao and Taiwan are subject to its provisions[14].

Joint Committee

According to the Notice, a joint committee (the “Committee”) shall be established at the inter-ministry level under the State Council[15] The Committee will be led by the NDRC and MOFCOM, and will be overseen by the State Council. The Committee shall involve other relevant ministries and governmental agencies in its activities, depending on “the industries and areas involved”[16]. The major responsibilities of the Committee include: (i) analyzing the impact of transactions on China's national security, (ii) analyzing and coordinating major issues during the security review process, and (iii) conducting security reviews of applicable transactions and making decisions accordingly[17].

Substantive Standards

Without further elaboration, the Notice lays down four criteria for evaluating transactions:

(i)"The impact of the transaction on national security, including the domestic production capacity, the domestic service capacity and related equipment and facilities needed for national security purposes.

(ii) The impact of the transaction on China's economic stability.

(iii) The impact of the transaction on China’s social order.

(iv) The impact of the transaction on China’s R&D capacity of critical technology related to national security”[18].

Initiation of Reviews by Application and Referral

The Notice establishes two channels for initiating reviews. First, the Notice explicitly requires foreign investors to submit applications to MOFCOM regarding covered transactions - they “shall” do so. The Notice does not, however, specify when the investors must file such a notice. Within five working days of such submission, MOFCOM “shall” submit any transaction falling under the scope of the security review to the Committee[19].

Second, if any department or agency of the State Council, any national industry association, any enterprise in the same industry, or any upstream or downstream enterprise believes that a transaction should be subject to the security review process, it may suggest to MOFCOM that a review be conducted. If the Committee determines that a review is indeed necessary, it may initiate the security review process[20].

The NRDC guidance published on February 16 indicates that no separate application for a security review must be filed, at least currently. It thus appears that for now, the Committee will proceed under the second channel for initiating a review, based on information provided the parties in the course of existing foreign investment approval processes.

Two-Stage Review Process

The Notice outlines a two-stage review process entailing a general review and special review (or an extended review). According to the Notice, the Committee shall first conduct a general review of a transaction submitted by MOFCOM. If the Committee does not clear the transaction after the general review, then a special review shall be conducted[21].

General reviews will be conducted through written inquiries. The Committee shall solicit opinions from relevant agencies within five working days after the submission by MOFCOM. Relevant agencies shall provide their opinions in writing within 20 working days after the opinion solicitation notice. If all the relevant agencies find that the transaction has no impact on national security, then no special review is required. The Committee shall issue the decision within five working days after receipt of all opinions and inform MOFCOM in writing[22].

If any agency finds that the transaction may potentially have any impact on national security, the Committee shall start the special review process within five working days after receipt of such opinion in writing. The Committee shall organize a security assessment of the transaction and review the transaction in connection with such assessment. If there is a general consensus by the members of the Committee, the Committee shall issue a final decision based on such consensus. If there is any major disagreement among the members of the Committee, the Committee shall submit the case to the State Council for further review. A special review shall be completed (or submitted to the State Council) by the Committee within 60 working days after the launch of the special review[23].

Written Decisions

The results of the review will be communicated to the applicants in writing by MOFCOM[24]. If a transaction has already had, or would reasonably be expected to have, a material impact on national security, the Committee shall request that MOFCOM, together with relevant agencies, order the parties to terminate the transaction, or order the parties to take necessary measures (such as transferring shares or assets) to eliminate such impact on national security.

Rights and Obligations of Parties

The Notice requests the Parties to the transaction to cooperate with the Committee, to provide relevant materials and information, and to respond to inquiries[25]. It does not specify, however, what materials and information must be provided at the time of initial notification to MOFCOM.

Mitigation Agreements

During the process of security review, the applicant may revise the transaction structure or withdraw the transaction[26]. Similar to U.S. practice, the apparent intent is to permit the parties room to negotiate “mitigation agreements” to address potential national security concerns.

Other Review Procedures

The Notice confirms that transactions subject to review under existing regulations governing certain acquisitions of fixed assets investment or state-owned assets shall continue to be subject to such regulations[27]. Separate regulations will be issued for security reviews of transactions involving domestic financial institutions[28].

Commentary

After years of uncertainty, and with growing concerns that increasing domestic protectionism and economic nationalism in China would lead to sweeping new approval requirements for foreign investments, the publication of the Notice at last marks the path forward by establishing a firm framework for reviews of transactions on national security and related policy grounds. The State Council’s statements in the Notice regarding the positive role and effect of foreign merger and acquisitions, and the government’s willingness to receive public comments on such sensitive issues as national security reviews during the legislative process, are encouraging signs that the mechanism will be implemented with a degree of openness and transparency, and will not be applied arbitrarily to deter specific investments. Indeed, the drafters appear to have adopted many recommendations from commentators for revisions to the 2010 draft, notably by setting concrete deadlines for action by the committee and by deleting other provisions of concern.

The Notice clearly reflects an attempt to mirror the scope and practice of national security reviews conducted by CFIUS, and by comparable authorities in other developed countries such as Australia and Canada. At the same time, the new process is tailored to China’s particular legal and policy environment. In many practical respects it remains opaque and discretionary. Hopefully, many questions will be answered through promulgation of rules or guidelines by NDRC and/or MOFCOM.

Several features of the new national security review mechanism are especially noteworthy.

Scope of Covered Transactions

  • Although there is some ambiguity due to the structure of the Chinese text, based on the February 16 NRDC guidance,  it appears that the requirement that a transaction result in “actual control” of a Chinese enterprise applies to both the first and second categories of covered transactions.
  • The focus on actual control appears generally to be consistent with United States practice. “Control” may result from majority ownership or “actual” control, which would involve power to control various fundamental business operations or decisions of the enterprise.
  • Not all foreign investments in the second category that result in control of a domestic enterprise would, fall within the scope of the Notice. The language limits the scope of that category to transactions involving enterprises engaged in “important” sectors and ones involving “key” technology or “major” equipment. These qualifiers are both broad and undefined, however, and absent further clarification, it appears that a notice must be filed in order for an investor to learn whether a specific investment merits review. (For example, an investor in the agricultural sector has no guidance as to whether its investment happens to involve “important” agricultural products).
  • Transactions are subject to review regardless of the amount of the investment, so long as "actual control" of a domestic enterprise results. There is no minimum threshold amount, below which transactions are not subject to review if they otherwise fall within the Notice’s scope.
  • Physical proximity of a target enterprise to sensitive military installations will subject a transaction to review, regardless of the business in which the enterprise engages. This language is clearly inspired by recent decisions in Australia and the United States that effectively blocked proposed Chinese investments in mining companies that turned out to be proximate to military facilities[29].
  • As noted above, it remains to be clarified as to whether the Notice adds to prior rules a third covered transaction scenario involving the use of existing FIEs to acquire assets of and shares in domestic enterprises. The use of existing FIEs as acquisition vehicles has been a common strategy to skirt many formal approval procedures for foreign direct investment.
  • It does not appear that “greenfield” foreign investments - ones not involving the acquisition of “control” of a existing Chinese enterprise - are covered by the Notice.
  • “Actual” control may result from the acquisition by “several foreign investors” of more than 50% of a target enterprise, even if those investors are unrelated and their actions are not coordinated. (It is not clear what happens if “several foreign investors” acquire a significant, but not majority, stake in a the target. Presumably, the Committee may find control in those circumstances as well, at least if the investors are individually or collectively able to “materially influence” key actions of the enterprise.)
  • No guidance is provided about the role of typical minority shareholder protection provisions in determining whether “actual control” exists.
  • No guidance is provided about how convertible shares or lending transactions will be treated for purposes of determining “control.”

Review Standards

  • Section II of the Notice enunciates four substantive standards by which the Committee will review covered transactions. As in the United States and elsewhere, the concept of “national security” is not defined, and one should assume it will be interpreted broadly. Also like CFIUS, the Committee is directed to assess the impact of the investment on “critical technologies.” CFIUS rules specifically define “critical technologies;” perhaps the Committee will issues rules or guidance as well on this point.
  • Section II widens the scope of reviews well beyond national security by subjecting them to a test of their impacts on China’s “economic stability” and “social order.” There is no comparable test in the United States, but Canada and Australia, for example, both broadly take into account economic and social considerations in their foreign investment reviews[30].
  • It is not clear whether Article 12 of the 2006 M&A Rules has survived the enactment of Article 31 of the AML, or whether the concept of protecting “famous brands” in Article 12 is now encompassed within the four standards laid out in the Notice.

Procedures

  • The function of the initial five-day review by MOFCOM is not clear. For example, perhaps MOFCOM will determine the adequacy of notices before sending them to the Committee, or determine whether some transactions reported by parties do not merit national security review.
  • It is apparent that competitors and other private sector parties may encourage reviews by the Committee.
  • The Notice sets a timeline for reviews by the Committee that parallels the 90-day timeline governing the CFIUS process, including the initial 30-day review to determine whether a more in-depth review is warranted. As with CFIUS, the deadlines effectively may be extended by withdrawals from the reviews by the parties, followed by a refilling. Ambiguity in the language suggests that reviews may extend up to 95 days, depending on when the second-stage special review is commenced.
  • While the Notice requests the related departments and units to guard state secrets and commercial secrets, there is no explicit protection for the confidentiality of information submitted by parties in the course of the review[31].
  • The Notice does not provide for direct participation in the review by the parties.

Interaction with General Foreign Investment Regime

  • China’s general foreign direct investment approval system has been progressively decentralized in recent years, with provincial and local authorities receiving greater authority to approve larger projects in more industries without central government involvement. The new national security review system potentially will channel certain transactions to the central government for review (much like antitrust review under the AML).
  • The interaction between the general foreign direct investment approval procedures and the national security review process remains uncertain. For example, it is unclear whether provincial or local approval authorities will suspend their reviews or withhold their decisions pending the outcome of the national security review process.

While the Notice leaves open many questions about the scope and impact of Chinese national security reviews to be addressed through future rulemaking and enforcement activity, it provides foreign investors with valuable guidance on the basic principles and procedures for national security review of future investments in China. Meanwhile, investors will need to examine closely the potential application of the Notice to their proposed transactions and be prepared to navigate the new review process as an added regulatory approval.

[1] Guowuyuan Ban'gongting Guanyu Jianli Waiguo Touzizhe Binggou Jingnei Qiye Anquan Shencha Zhidu de Tongzhi [Notice of the General Office of the State Council on Establishing the Security Review Mechanism for Merger with and Acquisition of Domestic Enterprise by Foreign Investors] (the Notice), issued by the General Office of the State Council on Feb. 3, 2011, available at http://www.gov.cn/zwgk/2011-02/12/content_1802467.htm.
[2] http://www.sdpc.gov.cn/xwfb/t20110216_395284.htm
[3] Guanyu Waiguo Touzizhe Binggou Jingnei Qiye De Guiding [Rules for M&A of Domestic Enterprise by Foreign Investors], issued by the Ministry of Commerce, Commission of the State-owned Assets Supervision and Administration, the State Administration of Taxation, the State Administration for Industry and Commerce, China Securities Regulatory Commission, and State Administration of Foreign Exchange on August 8 , 2006, and amended by the Ministry of Commerce on June 22, 2009, available at http://www.mofcom.gov.cn/aarticle/b/c/200907/20090706416939.html?3808473952=906731732.
[4] See 2006 M&A Rules, art. 12.
[5] See See Xizhu Zhang and Vanessa Yanhua Zhang, The Antimonopoly Law in China: Where do we stand?, COMPETITION POLICY INTERNATIONAL, Autumn 2007, 185, at 193; Carlye Fails to Secure Stake in China Firm, ASIA WALL STREET JOURNAL, Jul. 23, 2008.
[6] Zhonghua Renmin Gongheguo Fanlongduan Fa [Antimonopoly Law of the People's Republic of China] (promulgated by the Standing Committee of the National People’s Congress on Aug. 30, 2007 and effective on Aug. 1, 2008), available at http://www.gov.cn/flfg/2007-08/30/content_732591.htm.
[7] See Zhengguo Wu, Perspectives on the Chinese Antimonopoly Law, 75 ANTITRUST L. J. 73, 101 (2008). See generally, 50 App. U.S.C.A. § 2170 (2007).
[8] Guojia Fazhan He Gaige Weiyuanhui Zhuyao Zhize Neishe Jigou He Renyuan Bianzhi Guiding [Rules on the Responsibility, Internal Organization and Staff System of the National Development and Reform Commission], issued by the National Development and Reform Commission on August 25, 2008, available at http://zfxxgk.ndrc.gov.cn/PublicItemView.aspx?ItemID={2050a9f4-cd8e-41de-836e-e2ea2a9950d5}
[9] Section I.1 of the Notice
[10] Id.
[11] (iii)(b) was not covered by the scope of transactions under the 2006 M&A Rules; the wording of (iii)(a) was included in the 2006 M&A Rules but is widely interpreted to exclude the use of existing (as opposed to newly established) FIEs as asset acquisition vehicles from the scope of the 2006 M&A Rules. It is not clear if the use of existing FIEs as asset acquisition vehicles is captured under (iii)(a) of the Notice.
[12]Section I.2 of the Notice
[13] See Section I.3 of the Notice
[14] See Section V.5 of the Notice
[15] See Section III.1 of the Notice.
[16] See Section III.2 of the Notice.
[17] See Section III.3 of the Notice.
[18] See Section II of the Notice.
[19] See Section IV.1 of the Notice.
[20] See Section IV.2 of the Notice.
[21] See Section IV.3 of the Notice.
[22] Id.
[23] Id.
[24] See Section IV.5 of the Notice.
[25] See Section IV.3 of the Notice.
[26] See Section IV.4 of the Notice.
[27] See Section V. 2& V.3 of the Notice.
[28] See Section V.4 of the Notice.
[29] See OMM Client Alert, “Location, Location, Location: Observations on CFIUS Opposition to Investment by Chinese Mining Company in Firstgold Corporation,” (Jan. 7, 2010), available at http://www.omm.com/newsroom/publication.aspx?pub=911.
[30] See “Minister of Industry Confirms Notice Sent to BHP Billiton Regarding Proposed Acquisition of Potash Corporation,” http://www.ic.gc.ca/eic/site/ic1.nsf/eng/06031.html; “Australia Blocked China Rare Earth Deal on Supply Concerns,” http://news.businessweek.com/article.asp?documentKey=1377-aOMenaxK5ti0-00EQIQA8VNOGJ8PR9RO9HI6HLS
[31] See Section V.1 of the Notice.