This Client Alert briefly introduces the current national security review (“NSR”) regime and highlights the key changes and outstanding issues of the Security Review Measures.
International trend to update national security reviews
Security reviews of foreign investments that affect or may affect national security are an international norm. Many leading jurisdictions have been ratcheting up their NSR procedures in recent years, for example, under the United States’ Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”), Regulation (EU) 2019/452 of the European Union, France’s Decree No. 2019-1590 and partner ministerial order (together, “French Decree”), as well as similar legislation in other major jurisdictions such as the United Kingdom, Germany and Japan. As governments in various countries tighten their grip on foreign direct investment review, the need for better assessment and calibration of the associated regulatory risks in cross-border transactions is greater than ever before.
China’s continuous efforts to fill in regulatory gaps
National security reviews are not new in China. In 2011, MOFCOM released the Provisions on the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (“M&A NSR Provisions”), providing details on the substance of China’s NSR procedures. However, such procedures did not cover greenfield foreign investment, such as newly established enterprises and new fixed asset investments.
In May 2015, the Chinese government released the Measures for Trial Implementation of National Security Review of Foreign Investment in Pilot Free Trade Zones (“FTZ NSR Measures”), extending NSR to other forms of foreign investment in addition to mergers and acquisitions in the four free trade zones.
In the new Foreign Investment Law (“FIL”) and its implementation regulations, which came into effect at the beginning of 2020, regulators inserted a generic clause to the effect that China will conduct NSR on foreign investments that have or may have a bearing on China’s national security and that decisions of the NSR will be final. However, the FIL does not contain any details about the NSR process.
Drawing upon the past experience in the M&A NSR Provisions and FTZ NSR Measures, the 23-clause Security Review Measures rest upon the FIL and the PRC National Security Law as legal basis and aim to effectively forestall and resolve national security risks while actively promoting and protecting foreign investment under a new development model. The main highlights of the Security Review Measures include:
Which authority is in charge of the NSR?
The State establishes a Working Mechanism to be responsible for organizing, coordinating, and directing the NSR work. The office of the Working Mechanism (“Office”) is set up under the NDRC but will be led by the NDRC and MOFCOM together. According to an NDRC announcement, applications for a NSR may be submitted to the NDRC administrative service center.
Which sectors are covered?
NSR applies not only to any foreign investment in the national defense sector but also to foreign investment in areas such as “important” agricultural products, energy and resources, equipment manufacturing, infrastructure, transportation services, cultural products and services, information technology and internet products and services, financial services, and key technologies where actual control over the enterprise will be obtained.
Similar to the undefined term “sensitive” in the M&A NSR Provisions and the FTZ NSR Measures, “important” is a key undefined term in the Measures. There is no further clarification on what this term covers. Instead, they direct any enquiries to the Office. Unlike the NSR regimes in other major jurisdictions, such as FIRRMA, which adopts an inexhaustive list of “key technologies” and “critical infrastructure” that fall under its review, the Security Review Measures only broadly enumerates some important industries.
As such, it remains to be seen whether Chinese authorities will also promulgate a reference list to guide NSR practices or take a discretionary approach for interpretation of the sector concerned.
Which types of transactions are concerned?
Under the Security Review Measures, NSR is required when a foreign investor will obtain “actual control” of an enterprise in one of the above “important” industries, meaning when:
- The foreign investor will hold more than 50% of the equity of the invested enterprise;
- The foreign investor will hold less than 50% of the equity of the invested enterprise, but enough voting rights to be able to have a significant impact on the resolutions of the board of directors, board of shareholders, or general shareholders’ meeting; or
- In other circumstances the foreign investor may have significant influence on the invested enterprise’s decision-making, human resources, finance, technology, etc.
The 50% threshold for “actual control” under the Security Review Measures is much higher than the 10% to 30% shareholding requirement under the NSR regimes of other major jurisdictions. However, as the Security Review Measures also contain a catch-all clause for “other circumstances the foreign investor may have significant influence”, even if the foreign investor holds less than 50% of the equity, considering the sensitivity of the investment sector and the consistent discreet attitude of the Chinese authority, it is possible that in practice such foreign investment would still be subject to NSR under the catch-all clause of the Measures.
Given the undefined nature of the catch-all clause, it may be possible to look to the M&A NSR Provisions and FTZ NSR Measures as a reference, as they both clearly set forth the types of transactions that fall within their ambits—namely, contractual control, proxy holdings, trusts, reinvestments, and overseas structures. However, whether in practice the Office will refer to these regulations when interpreting the types of transactions that fall under the purview of the Security Review Measures (such as the VIE structure) is to be further clarified.
In addition, the Security Review Measures include greenfield investments, or the establishment of enterprises in China by foreign investors. This type of investment is largely exempted from NSR by most other major jurisdictions, which tend to target only mergers and acquisitions. The inclusion of greenfield investment in the Security Review Measures could create complications for multinationals and non-Chinese companies looking to expand into China. How Chinese authorities will apply the measures in this respect from a practical perspective also remains to be seen.
What are the key steps and timeline for the NSR procedure?
The Security Review Measures require foreign investors or the parties concerned in China to take the initiative to declare any investment that is within the scope stipulated in the measures for NSR. If any foreign investment within the scope is not declared before the implementation of the investment, the Office is entitled to require declaration within a certain deadline.
Additionally, relevant organs, enterprises, social groups or the general public are vested with a right to suggest an NSR of certain foreign investments if they believe a transaction may impact national security.
Investors may request a pre-filing consultation to determine whether their transaction is subject to a declaration. However, the consultation mechanism under the Security Review Measures seems to lack any elaboration on the application materials, procedures, or legal effect of any consultation response given by the Office. How such pre-filing consultation will actually work in practice is to be further clarified.
The Security Review Measures establishes a three-stage review process once an application for NSR has been submitted:
- Preliminary review (15 working days): The Office will decide whether the reported foreign investment is, in fact, subject to NSR within 15 working days from the receipt of the materials submitted.
- General review (30 working days): If the Office decides NSR is required, it will conduct a general review. Within 30 working days from the date of decision, it must either clear the proposed transaction or, if it has determined that the transaction has or may have an impact on national security, proceed to the next level of review. During this general review period, the parties concerned may not make the investment.
- Special review (60 working days): The Office will initiate a special review only if a transaction failed the general review. The special review must be completed within 60 working days after it was started, although under special circumstances the review period may be extended. During this special review period, the parties concerned may not make the investment.
After the NSR, the Office must hand down one of three decisions:
- If the Office concludes that the proposed transaction has no impact on national security, the parties concerned may proceed with the transaction;
- If the Office concludes that the proposed investment does have an impact on national security, it may prohibit the transaction and the parties may not make the investment; or
- If the impact on national security can be eliminated, the Office may approve the transaction with certain strings attached and the parties may proceed with the transaction with the additional conditions.
Are there any sanctions for non-compliance?
In case of any non-compliance, such as refusing to report a reportable transaction, making false statements, concealing a transaction, or failing to fulfill any additional conditions, the parties to the transaction may be ordered to rectify and/or restore the equity holding to its original status and their credit rating in the national credit information system may be negatively impacted. They may also be subject to joint punishment by the competent authorities.
The sanctions set forth in the Security Review Measures are quite simple and straightforward. It remains to be seen whether such sanctions are effective in practice. The NSR regimes of other major jurisdictions allow for more diverse means that may better protect public order and interests. For example, under the French Decree, a per diem penalty and precautionary measures, such as suspending the investor’s voting rights and preventing the investor from disposing of assets or receiving dividends, may be imposed in cases of emergency, exceptional circumstances, or imminent threat to the public order. We will see if there will be any changes or evolution to the Security Review Measures in regards to intermediate measures.
As mentioned above, the expanded scope of the Security Review Measures and their potentially broad application through vague provisions have raised concerns that the measures may impose extra burden on foreign investment. Further guidance is expected to clarify these vague provisions.
Furthermore, China currently regulates foreign investment with a “pre-entry national treatment regime plus negative list”. Foreign investment in industries on the negative list are already subject to special regulations and supervision by MOFCOM. With the issuance of the Security Review Measures, questions arise for foreign investments that both fall under the negative list and require NSR (such as investments in the information technology and internet products and services sectors). For example, what are the applicable review standards and the sequence between the two approval procedures? It is subject to further clarification by the Office.
Foreign investors should carefully monitor these regulatory developments and any clues from regulators. In particular, multinational companies are advised to perform a risk analysis for each transaction in areas that are the target of NSR, consider resorting to the pre-filing consultations with the Office, and include risk allocation provisions in transaction documents.
This Client Alert was prepared by partner Fan Jiannian, with associates Cao Can and Cao Munan.
Gide will continue to keep you abreast of any updates and clarifications in this regard. In the meantime, please do not hesitate to get in touch with any questions you may have.
This legal update is not intended to be and should not be construed as providing legal advice. The addressee is solely liable for any use of the information contained herein and the Law Firm shall not be held responsible for any damages, direct, indirect or otherwise, arising from the use of the information by the addressee.