By Dan Harris
On January 1, China will allegedly have a new Foreign Investment Law. I say allegedly because even at this late date, none of the respected China lawyers with whom I have spoken are convinced it will change anything. The same holds true for all the other China lawyers at my law firm.
I have been consulting regularly on this law with co-blogger Steve Dickinson because Steve was such a central figure in China’s New Company Law (still largely in force today), enacted on January 1, 2006. I say this because Steve was chosen to write the China corporate governance law chapter for the leading corporate law desk-book (back when there were such things), chosen to be the first foreign lawyer to speak in China (in Chinese before Chinese lawyers) on the new laws, and chosen to write a scholarly article on those laws by one of the leading the Pacific Rim Law & Policy Journal, which was one of the leading Asia law journals back then.
Earlier this year, Steve wrote a series of posts on what the new Foreign Investment Law is and is not, with a focus on how the media and many commentators have wrongly ascribed great things to it. See New China Foreign Investment Law: Not Good News, China’s New Foreign Investment Law and Forced Technology Transfer: Same As it Ever Was and China Approves New Foreign Investment Law to Level Playing Field for Foreign Companies. MEH.
Back in April, in China’s New Foreign Investment Law Benefits: Like Putting Lipstick on a Pig, Steve set out how the new Foreign Investment Law might “positively impact foreign investment in China”:
The core concept of China’s new Foreign Investment Law is that of national treatment. Under this principle, foreign investors will be treated the same as Chinese investors. WFOEs and Sino Foreign Equity Joint Ventures will disappear. If this policy is followed, then at least the following changes that could benefit foreign investors will be the result:
1. The procedure for forming foreign owned companies in China will be radically simplified. It currently takes many months to form a WFOE or a JV. See Forming A China WFOE. How Long Will That Be Going On? China’s WFOE and Joint Venture policies are constantly changing and yet forever unclear and the processes vary from jurisdiction to jurisdiction. It is nothing like forming a company in the United States, Canada, Hong Kong, the EU, Australia, etc. On the other hand, forming a Chinese owned domestic company is simple, fast and inexpensive and very much like forming a company in the United States, Canada, Hong Kong, the EU, Australia, etc. In many Chinese cities, forming a domestic Chinese company can take as little as one week and the costs of doing so are relatively trivial. Under the new Foreign Investment Law, this simplified system should apply to all forms of foreign invested enterprise: both wholly foreign owned and mixed Chinese foreign owned. Costs and timeframes should radically decrease.
2. Foreign investors will be permitted to acquire stock in private Chinese companies. See China Scam Week, Part 4: The China Stock Option Scam. Our clients often come to our China corporate lawyers with well plans to purchase a non-controlling interest in a Chinese company. Under the current rules, the only way to do this is to restructure the Chinese entity as a joint venture. This seldom makes legal sense and so this kind of purchase is seldom practical. Under the new system, foreign investors should be permitted to acquire ownership interests in existing Chinese companies on the same basis as a Chinese investor. This should open many areas of economic cooperation not possible in the current system. For example, this should allow Chinese companies to pay for technology or high tech services with their own stock rather than in cash.
3. Many high tech Chinese companies want to hire foreigners and expats to work in their companies. The standard employment package in this sector includes stock options. Under China’s current system, Chinese companies cannot offer stock options due to the prohibition on foreign ownership. Because of this prohibition on foreign ownership, complicated and often unenforceable nominee structures are used, causing no end of problems as these structures unravel. Under the new system, Chinese companies should be able to offer stock options to foreign employees the same as they offer the stock options and other stock based incentives to their Chinese employees.
4. In the U.S. and Europe, it is common to structure investor company ownership that departs from a straight one RMB for one share arrangement where all shareholders are treated in exactly the same way. For example, common alternatives are a) sweat equity, where some shareholders make no cash payment but get stock in exchange for employment and b) preferred returns, where certain shareholders are granted a right to profits greater than their ownership percentage. Under China’s current system, where there is a Chinese/foreign joint venture arrangement, this type of innovative ownership/return policy is often prohibited by local governments. But under China’s new Foreign Investment Law, local governments should be removed from this sort of supervision and approval of private financial arrangements and the use of complex shareholder and partnership agreements should become accepted, greatly increasing the flexibility of foreign investment in China.
5. Under China’s current system, it has been mostly impossible for foreign investors to effectively form and operate investment funds. When forming WFOEs and Joint Ventures, local governments almost always insist that a specific project be identified and that the registered capital of the WOFE/JV be focused exclusively on that single venture. This has made it nearly impossible to form a WFOE or Joint Venture that openly states that it will engage in a series of investments in currently unidentified projects. In addition, the PRC allows general and limited partnerships. Though these partnerships are a common (even preferred) structure for investment funds, foreign investors have been effectively prevented form making use of these structures. Under the new Foreign Investment Law’s national treatment system, this all should change and the vast Chinese investment fund market should open to foreign investors, either operating on their own on in partnership with Chinese investors.
Steve then wrote how all of the above possible benefits are subject to two significant limitations that could render make even these benefits illusory:
First, we will not know how this new system will work until after formal rules are issued and adopted and it becomes clear what local governments will actually do in this area. I have been following China’s national treatment/negative list plan since 2015 and I have not seen a single mention in the Chinese language government/policy analyst discussions the five issues I discuss above. It is almost as though the Chinese authorities are unaware that these five changes are a natural result of a consistently applied national treatment system. Since these five changes will radically break from decades of Chinese government practice, it is an open question as to what will actually happen when China’s new Foreign Investment Law comes into effect. A healthy dose of skepticism is therefore appropriate.
Second, the opening up measures I discuss above will remain constrained by China’s fundamentally closed economy. As I discussed in New China Foreign Investment Law: Not Good News, foreign investors are consigned to a small playing field within the Chinese economy. So the rights that appear to open under the new Foreign Investment Law may be largely illusory. Put simply, for sectors of the Chinese economy prohibited to foreign investment, foreign investors will not have any of the new rights under the new Foreign Investment Law.
For example, consider stock options. If the industry sector is prohibited to foreign investment, the right to issue stock options to foreign individuals will also be restricted and most expats who would be offered stock options will be working in high tech businesses prohibited to foreign investment. Investment in fin-tech, high speed securities trading, insurance company investment analysis, software as a service (SaaS), Internet products of all kinds, Internet gaming, online e-commerce are all prohibited or severely restricted for foreigners. Foreign individuals employed by Chinese banks and other major SOEs will also not be allowed to invest in their employers, via stock options or otherwise.
What then will actually change under China’s new Foreign Investment Law? So long as China’s economy remains largely closed, the answer is that very little will change. The real issue with China’s treatment of foreign investors is that China continues to protect its domestic economy against foreigners. That level of protection was perhaps appropriate for China in the 1980s and 1990s, but it is not appropriate for a China that is now the second largest economy in the world. But as the US-China trade talks have only reinforced, the Chinese government has no plans to reduce its stronghold over China’s economy. If China does not open its economy to foreign investment (which is exceedingly unlikely to occur), all of the above five changes (even if they do occur, which itself is far from certain) will be little more than putting lipstick on a pig.
China’s new Foreign Investment Law is a sleight of hand magic trick of the type so popular on Chinese television. Seeing through this illusion is the first step. The second step would be to force the Chinese government to open its domestic market in all the areas where it is currently. I have seen no discussion at all of the second step. Until China takes the second step its new Foreign Investment Law will change little.
With January 1 rapidly approaching, I sought an update from Steve and a number of other of my law firm’s China corporate lawyers, and the below seems is their consensus, at least as of yesterday: