alerts & publications

China (Shanghai) Pilot Free Trade Zone - From “One Country Two systems” to “One Country Multiple Systems”?

September 29, 2013 marked the inauguration of the much-anticipated China (Shanghai) Pilot Free Trade Zone (the “Free Trade Zone”). On August 22, 2013, the State Council approved the establishment of the Free Trade Zone in Shanghai’s Pudong District[1]. On August 30, 2013, the Standing Committee of People’s Congress issued a Decision on Authorizing the State Council to Temporarily Adjust Administrative Approvals under Relevant Laws within China (Shanghai) Pilot Free Trade Zone (the “Decision”). Further to issuance of the Decision, on September 27, 2013, the State Council released the General Plan for China (Shanghai) Pilot Free Trade Zone (the “General Plan”), which sets out a high-level roadmap for the proposed regulatory reforms in the Free Trade Zone, including a list of 17 industries that will be open to or further liberalized for foreign investments.[2]

China’s central government has positioned the Free Trade Zone as the testing ground for a set of regulatory reforms that could tremendously alter the landscape for investments in China. It is understood that the above published sources likely do not capture the full extent of the reform schemes contemplated by the central government. Premier Li Keqiang famously asked some officials in Shanghai earlier in the year, “[W]ould you rather have more [central government] policy incentives or more [real] reform?”, drawing a distinction between the ambitions of the Free Trade Zone and prior pseudo-reform programs often propelled solely with government policy concessions. So far, China, a hugely diverse country, has been largely governed centrally from Beijing in a more or less uniform fashion. Many argue that the more economically developed regions of China, such as Beijing, the Yangtze Delta Region and the Pearl Delta Region deserve a more modern form of governance, at least insofar as commercial dealings are concerned. Several open questions await answers in the coming months and years: how far-reaching will the reforms in the Free Trade Zone turn out to be, will the regulatory reforms usher in deeper legal reforms, can one expect the Chinese legal regime in its financial hubs to start resembling the legal regimes of the world’s other great financial centers?

Some key highlights concerning the Free Trade Zone are summarized below. They are prepared based on publicly available sources of information as of the date of this alert.

Industries Liberalized for Foreign Investments

Pursuant to the General Plan, restrictions on foreign investment are wholly or partially waived for a total of 17 industries within the Free Trade Zone. The key changes in some of these industries are outlined below:

• Financial Services: qualified foreign investors may establish wholly foreign-owned banks or joint venture banks with private investors in China; Chinese banks may be allowed to conduct business offshore with non-PRC residents; foreign-invested health insurance companies may be set up in the Free Trade Zone on trial basis;
• Telecommunications: foreign investors are granted access to certain value-added telecommunications businesses (details to be announced) and, upon special approval of the State Council, will be exempt from certain regulatory restrictions;
• Professional Services: foreign investment is permitted in credit investigation agencies, travel agencies, and recruitment agencies; foreign investment restrictions on engineering and construction agencies servicing Shanghai are removed; foreign-invested equity investment companies may be structured as companies limited by shares, allowing for possible listings on the A-share market in the PRC;
• Cultural and Entertainment: 100% foreign ownership is allowed for talent agencies servicing Shanghai and recreational facilities located in the Free Trade Zone; and
• Education, Medical Services/Healthcare: for-profit education and training institutions and for-profit professional training institutions may be jointly formed by foreign investors and PRC persons; and wholly foreign-owned medical institutions may be established by foreign investors.

Waivers from Approval Requirements for Foreign Direct Investments and Outbound Investments

The Decision waives approvals normally required from the Ministry of Commerce or its local counterpart (“MOFCOM”) for the establishment (including for the effectiveness of the joint venture contract and articles of association of FIEs), term extension, material post-establishment changes and dissolution of foreign-invested enterprises (“FIEs”) formed in the Free Trade Zone. In lieu of such waived approval requirements, foreign investors or FIEs need only to make filings for the aforesaid matters with the competent Free Trade Zone authority.

The new filing mechanism represents a major departure from China’s longstanding approval-based system for foreign direct investments. Foreign investors investing in the Free Trade Zone can expect greater efficiency and convenience in implementing business strategies without being hampered by the time-consuming and sometimes unpredictable approval process. In addition, because joint venture contracts and articles of association of FIEs in the Free Trade Zone no longer require approval from MOFCOM, foreign investors using joint venture structures will be able to utilize more flexible deal terms, such as those commonly found in offshore or pure PRC domestic deals. With a simplified regulatory clearance process and greater deal term flexibility for foreign direct investments in the Free Trade Zone, it is likely that more and more foreign investments using joint venture structures will be channeled to the Free Trade Zone.

Furthermore, the General Plan requires only filings with, instead of having to obtain approvals from, the competent Shanghai authority for outbound investments made by enterprises formed in the Free Trade Zone. This would significantly simplify the regulatory clearance process for outbound investments and could potentially establish the Free Trade Zone as a hub for outbound investments by PRC enterprises.

Negative List Approach for Foreign Investments

A negative list approach is adopted pursuant to the General Plan for foreign investments in the Free Trade Zone. A negative list is a list of industries concerning national security and other sensitive industries that are restricted or forbidden for foreign investment. Foreign investors will be able to invest in every industry that is not on the list and enjoy national treatment in terms of market entry in the Free Trade Zone without being subject to any approval requirement (instead, subject to post-transaction filings). It is expected that, under such approach, more and more industries that are currently subject to foreign investment restrictions (whether legally or practically) will open up for foreign investment in the Free Trade Zone. The 2013 version of the negative list has been issued by the Shanghai government and there may be updates in the coming years. Other than those industries being specifically opened up to foreign investors in connection with the launch of the Free Trade Zone (see above for a high-level summary), which are included in the negative list, the 2013 version of the negative list basically includes all the categories that are restricted (including items under the encouraged category but with specific shareholding or investment structure restrictions) or forbidden for foreign investment under the Foreign Investment Industrial Guidance Catalogue (2011 Catalogue). However, the negative list did offer some helpful guidance on foreign investment in certain industries. For example, the negative list clarifies that investment in app stores is not subject to any shareholding limitation and foreign investors can invest up to 55% in in operational e-commerce businesses.

Capital Account Convertibility etc.

Free convertibility of Renminbi (“RMB”) will be implemented on a trial basis in the Free Trade Zone as part of the PRC government’s financial regulatory reform package. Under current PRC foreign exchange regulations, conversion between RMB and a foreign currency is permitted for current account transactions, but is subject to approval for capital account transactions, such as foreign equity investment and foreign debt. In addition, FIEs are generally not permitted to convert foreign currency into RMB for investments in other PRC companies or the real estate market in China. If foreign currency is allowed to be freely converted into RMB in the Free Trade Zone and flow to other regions of China, or if RMB is allowed to be freely converted into foreign currency in the Free Trade Zone and transmitted overseas for investment or other purposes, cross-border transactions through the Free Trade Zone will undoubtedly increase.

In addition, commercial banks will be allowed to, on trial basis, freely determine interest rates in the Free Trade Zone. The central government also expects the Free Trade Zone to play an importation role on the internationalization of RMB.

However, these policies are all subject to the issuance of more detailed implementation rules by the relevant authorities, and it is hard to predict how they will play out.

[1] The Free Trade Zone will be based on the existing bonded zones in Shanghai, including Yangshan Bonded Port Area, Waigaoqiao Bonded Zone, Waigaoqiao Bonded Logistics Zone and Pudong International Airport Comprehensive Free Trade Zone, and initially cover a total area of 28 square kilometers. Detailed implementations rules for the Free Trade Zone are expected to be released later this year.

[2] The General Plan contains a list of 18 industries that will be affected by the new regulation, 17 of which pertain to foreign investment.

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This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Qiang Li, an O'Melveny partner licensed to practice law in New York, Walker Wallace, an O'Melveny partner licensed to practice law in New York, and Ning Zhang an O'Melveny Counsel licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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