Impacts of Newly Adopted Foreign Investment Law on Existing FIEs
On March 15, 2019, the long-awaited Foreign Investment Law (“FIL”) was approved and promulgated by the National People’s Congress. FIL will come into force on January 1, 2020 and will, upon effectiveness, replace the three long established basic laws regulating foreign direct investment activities in China, i.e., Sino-Foreign Equity Joint Venture Law (“EJV Law”), Sino-Foreign Cooperative Joint Venture Law (“CJV Law”), and Wholly Foreign Owned Enterprises Law (“WFOE Law”, together with EJV Law and CJV Law, collectively referred to as “FIE Laws”).
Since 1980s, accompanying China opening itself to foreign investors, FIE Laws and their respective implementing rules has played significant roles in attracting foreign investors and regulating foreign investment activities in China. FIE Laws established three different types of foreign invested enterprises (“FIEs”): Sino-foreign equity joint ventures (“EJVs”), Sino-foreign cooperative joint ventures (“CJVs”) and wholly foreign owned enterprises (“WFOEs”). FIL is expected to fundamentally change the corporate structure and corporate governance of existing FIEs, especially EJVs and CJVs. This article will discuss such changes and potential actions required for existing EJVs and CJVs in order to comply with the newly adopted FIL.
1.Restrictions on Individuals as Chinese Shareholders
EJV Law expressly excludes Chinese individuals from being shareholders of FIEs, with certain exceptions, such as existing Chinese individual shareholders of a domestic company being acquired by foreign investor(s). FIL, however, adopts a very general description for FIEs’ shareholders -“other investors”, which provides room for Chinese individuals to jointly establish a FIE with foreign investors or invest in an existing FIE.
2.Minimum shareholding percentage of foreign investor(s)
According to EJV Law, the minimum shareholding percentage of foreign investor(s) in an EJV shall not be lower than 25%. FIL now abolishes such minimum shareholding requirement and places no restriction or requirement regarding foreign investors’shareholding percentage, which will allow the shareholders to freely negotiate and decide their respective investment commitments in an FIE.
3.Capital contribution by technology or know-how
Under EJV Law, foreign investors are only allowed to use “advanced technology, know-how or equipment that fits China’s needs” as capital contribution to a FIE. If the invested technology, know-how and/or equipment is determined to be outdated, the investors may be required to make compensation to the FIE. Requirements for determining “advanced” technology, know-how or equipment were set forth in the implementing rules of EJV Law, such as capable of markedly improving the performance, quality or existing products and raising productivity, and capable of notably saving raw materials, fuel or power. These are no longer restrictions or requirements on the technology, know-how or other non-cash contributions made by foreign investors under FIL. Foreign investors will have much wider choice and less burden on non-cash contributions to an FIE.
4.Supreme authority within FIEs
Unlike domestic companies or WFOEs, the supreme authority within an EJV is the board of directors, pursuant to EJV Law. With the unified corporate governance requirements under FIL, the supreme authority of an EJV will be shifted to the shareholders’ meeting. This will make the fights over board seats be less controversary as most of the major decisions of an EJV may be made by its shareholders’ meeting or written consents unless being delegated to the board by shareholders’ resolutions.
Another implication of this change is that fundamental matters of an EJV, such as change to its articles of association, increase or decrease in registered capital, winding-up, or merger/spin-off, which are currently required to be decided by unanimous approval of the board will in the future be approved by shareholder(s) representing 2/3 voting rights (or a higher ratio agreed by the shareholders in the EJV’s articles).
The directors of an EJV are currently directly appointed by each shareholder according to their respective shareholding percentage. nder FIL, the directors will be elected by shareholders’ meeting rather than direct appointment. The investors, however, may still, by signing a shareholders' agreement, be able to agree on an alternative mechanism that will allow them to appoint their own director candidates. For example, the shareholders agreement can provide that each investor may nominate certain number of candidates for board members, and other investors shall be obligated to take actions to caused such candidates being successfully elected in the shareholders’ meeting.
Unlike domestic companies or WFOEs, EJV currently is not required to have supervisors. FIL unifies the requirement for a sole supervisor or a board of supervisors being part of the corporate governance in all FIEs. This means EJV will also have supervisor positions in the future.
EJV Law expressly provides that the chairman of the board shall serve as the legal representative of an EJV, while FIL allows either the chairman/executive director or general manger to serve as the legal representative. This will offer more balance to the parties in deciding the allocation of each party’s representation in an EJV, such as one party appointing the chairman while the other party appointing the general manager who will also be the legal representative of the EJV.
8.Chairman vs Vice chairman
EJV Law provided that if one party to an EJV appoints the chairman, the other party shall be entitled to appoint a vice chairman. Similar arrangement is also applicable as to the allocation of general manager and deputy general manager appointment. FIL no longer has such restrictions. The parties to an EJV will have more flexibility in deciding the allocation of chairman position and senior management personnel among themselves.
Under EJV Law, the profit sharing and loss bearing among shareholders must be in proportion to their respective contribution to the registered capital of the EJV, while FIL provides the same mechanism as a general principle, but also allows the shareholders to decide otherwise among themselves. This will enable special arrangements for profit sharing usually required by PE investors.
10.Equity transfer restriction
EJV Law requires unanimous consents from all shareholders for a proposed transfer of equity, which does not differentiate transfer among shareholders and transfer to third parties. FIL allows shareholders to freely transfer among themselves without subject to consent rights of other shareholders, while with respect to transfer to third parties, consents from more than half of all other shareholders will be required. FIL also provides an exception that if shareholders intend to implement other equity transfer restrictions, they may include such restrictions in the articles of the EJV.
11.Mandatory reserve funds
There are three types of mandatory reserve funds required to be reserved from EJV’s after-tax profits before profit distribution: corporate reserve fund, employee bonus and welfare fund, and enterprise expansion fund, the ratio of which are to be determined by the board. FIL unifies the types and ratios of the reserve funds for all forms of FIEs. Same as domestic companies, FIEs must set aside statutory reserve that amounts to 10% of the after-tax profit (accruement ceases if the aggregate sum of the statutory reserve reaches 50% of the FIE’s registered capital) and discretionary reserve at the rate decided by the shareholders.
CJV was very popular in the early stage of China’s opening itself to foreign investments. With the flexibilities in corporate structure and corporate governance, especially regarding capital contribution and profit/loss sharing, CJV was welcomed by foreign investors that seek for uncommon arrangements with its Chinese partners. In the recent decades, less investors chose CJV as the legal form of their investments in China. As CJV Law will be replaced by FIL, CJV will no longer be a valid legal form for foreign investment in the future.
Ⅲ.Actions to be taken by FIEs in compliance with FIL
FIL provides a five-year transition period for all FIEs formed prior to the implementation of FIL. During this transition period, all FIEs must adjust their legal form and/or other aspects to comply with FIL. These changes will include but not limited to (i) change of CJV’s legal forms for their existing form to either a corporation or a partnership, (ii) modification of EJV’s existing rticles (to change the supreme authority, director appointment arrangement, appointment of supervisor or establishment of a board of supervisors, etc.) and joint venture contract in compliance with the new corporate governance requirements under FIL.
There are lots of local and/or governmental regulations and rules related to FIE Laws or otherwise applicable to FIEs, such as foreign exchange regulations and tax regulations related to FIEs, as well as registration formalities related to the establishment, change or liquidation of FIEs. We are expecting to see the promulgation of amendments and/or replacements of these rules and regulations in the near future.
Although FIEs are free to choose when to make changes, we suggest all FIEs review their corporate governance as soon as possible and consider making necessary modifications to their articles and/or joint venture contracts as early as possible. Waiting for the last moment to make necessary reviews and modifications may create problems for the FIEs’ operations and interactions with government authorities, though no penalty for missing the deadline of transition is specified yet.
We are ready to assist our clients and other foreign investors in need to review their current corporate governance and revise their EJV’s AOA and joint venture contracts according to FIL.