Ning Zhang, Partner
China’s Network Security Law (the “NSL”), adopted late last year, is set to take effect on June 1, 2017. One of the most important provisions of the NSL is Article 37, which requires operators of critical information infrastructure to store personal information and important data within China. Transferring such information overseas is only permitted after the information is assessed by the competent authority. Critical information infrastructure is broadly defined in the NSL as any information system important to national security, citizen welfare, and public interests, such as public communications and information services, energy, transportation, water conservancy, finance, public services, e-government and other important industries and fields.
On April 11, 2017, the Chinese Cyberspace Administration published a notice on its website (http://www.cac.gov.cn/2017-04/11/c_1120785691.htm), seeking public comments on its proposed rules for security assessment of transfer of personal information and important data abroad (the “Proposed Rules”), which are essentially administrative rules to implement Article 37 of the NSL.
However, there is one glaring difference between the Proposed Rules and Article 37 of the NSL. Although network operators are similarly defined in both the NSL and the Proposed Rules as owners or managers of network and network service providers, the Proposed Rules impose the data export restrictions not only on the operators of critical information infrastructure, as in the NSL, but also on all other network operators.
EU’s data protection practice drew a lot of criticism by prohibiting companies from transferring personal data of EU citizens to countries which have not been deemed to provide an “adequate” level of data protection. In comparison, China's restriction on data export under the Proposed Rules is much more extensive and stringent. As will be discussed in further details below, China not only limits cross-border transfer of personal information, but also requires security assessment for transfer of "important data", which is vaguely defined to be data that is closely related to national security, economic development, and societal public interests, with specific reference to some yet-to-be-published guideline. In addition, certain data cannot be transferred whatsoever.
If the Proposed Rules are adopted as is, which is speculated to be the case, personal information and important data collected and generated in China are required to be stored in China. If such personal information or data needs to be transferred overseas, safety assessment should be conducted either by the network operators or by the relevant regulatory authorities, depending on the nature of the personal information or data.
I. Data that cannot be transferred abroad
The following data is not allowed to be transferred overseas:
II. Data that can be transferred but is subject to self-assessment by network operators:
Prior to transfer any personal information or important data, the network operator should carry out security assessment for the data transfer at least on an annual basis. The Proposed Rules suggest seven factors as the focus of the assessment:
III. Data that can be transferred with administrative approval
If the personal information or important data meets any of the following requirements, the network operators should report the prospective data transfer to relevant industry regulatory or supervisory authorities (or the national cyberspace administration if the regulatory or supervisory authorities cannot be ascertained), which will be responsible for the security assessment:
Even if certain information covered by the Proposed Rules luckily falls under the self-assessment category (category II above), the network operator still faces significant compliance risks, as it is required to report the self-assessment to the industry regulatory or supervisory authorities and will be held responsible for the assessment results. In additional, the network operator not only needs to assess the personal information and important data itself, but is also required to assess the capability and security protection levels of the data recipient and the risk of the data being stolen or otherwise comprised during re-transfer overseas, which is hardly something that the network operator can easily determine with certainty. Thus, many Chinese companies, especially the ones with risk-averse compliance policies, are likely to turn to domestic partners in transactions where data exchanges are necessary, including the much anticipated rise of big data, deep learning, cloud services, SaaS, to name a few. For companies who find it a business necessity to transfer data overseas, for example, due to auditing or securities disclosure requirements, they are encouraged to set up internal security assessment procedures based on the factors in the Proposed Rules or, if they do not have adequate internal compliance or legal resources, to engage outside experts to conduct the security assessment to minimize compliance risks.
The VIE structure has been a success in the past decade commercially, but it also has certain legal risks, mainly the potential disputes between the legal shareholders (nominee shareholders) and the actual foreign shareholders and the legal enforceability of the various contracts under Chinese law. Chinese law allows a court to invalidate a contract if the purpose of the agreement is illegal. Many commentators pronounced the VIE structure essentially dead after China’s Ministry of Commerce issued a draft Foreign Investment Law for public comment in January 2015. The draft law expressly provided that Chinese domestic companies having no foreign shareholders but “controlled” by foreign investors contractually be subject to the same restrictions as those imposed on foreign invested companies. The draft law even went as far as indicating that the then-existing VIE structures could all be deemed illegal (no grandfather rules) unless special exemptions are granted on a case-by-case basis if the Foreign Investment Law is adopted.
The VIE structure indeed seemed to lose its luster, especially among Chinese companies, due to the ease of the IPO flow by Chinese regulators and the launch of the New Three Board (OTC equivalent market). Many Chinese companies with existing VIE structures commenced the process of converting back to domestic companies in order to apply for domestic listing or fund raising. Moreover, the recent restrictions on the outflow of RMB in China have further accelerated this trend as fewer Chinese companies now have the ability to raise sufficient capital from foreign investors without resorting to RMB-sourced funding in China. After all, with few exceptions, most Chinese companies are still relying upon Chinese investors for financing.
The VIE structure, however, did not die as many have thought, at least not yet. As the legislative process of the Foreign Investment Law is moving rather slowly, the legality of the VIE structure, especially existing ones, remain a hotly debated issue amongst Chinese legislators. In a recently published case, the Supreme People’s Court of China actually surprised many legal scholars with its finding that the framework agreement between a domestic education institution and Ambow Education, a domestic operating entity under VIE control by foreign investors, was valid.
Foreign investment in education industry is restricted in China. When Ambow Education, a provider of educational and career enhancement services in China, got listed on the NYSE in 2010, its Chinese operating entities were controlled by a VIE structure similar to the one illustrated above. Ambow Education, however, did not stop with just one operating entity in China. Before it went public, its Chinese operating entity entered into a series of transactions to purchase the control right and revenue from other Chinese educational institutions for lump sum payments. The plaintiff of the case entered into such a framework agreement with Ambow Education’s Chinese operating entity in 2009. The structure is illustrated below:
The framework agreement reviewed by the Supreme People’s Court in the Ambow Education case is very similar to the framework agreements often used in a VIE structure whereby a domestic company typically transfers its control rights and revenue to another foreign entity or foreign owned entity contractually (the agreement between the OpCo and WFOE in the VIE illustration above). Nevertheless, the Supreme People’s Court drew a distinction between the transfer of controlling rights of a domestic company to another domestic company that is under VIE control of a foreign entity (i.e., the OpCo) and the typical VIE structure where the control rights and revenue of a domestic company get transferred directly to a foreign owned entity. The Court found that the foreign investors of Ambow Education did not assert improper influence on its Chinese operating entity’s operations during its five-year control, and, therefore, in the absence of applicable administrative prohibition of transferring contractual control rights or revenue from one Chinese entity to another, the framework agreement cannot be invalidated solely based on the indirect equity holdings by foreign investors.
Although Chinese courts do not need to follow case law precedents, including the Supreme People’s Court’s rulings, the Ambow Education ruling offers useful guidance on how to create a "safe harbor" for a contractual control and the revenue transfer arrangement. Thus, a similar contractual control and revenue transfer agreement is more likely to be upheld by a Chinese court going forward if (a) another Chinese domestic company is the recipient of such control rights and revenue; (b) the arrangement does not trigger any national security concern; (c) there is no material operational interference from the foreign investors that is prohibited by applicable law; and (d) there is no administrative prohibition of such contractual transfer of control rights and revenue in the relevant industry.
The Ambow Education ruling does not expressly address the validity of the existing VIE structures as of today. However, the reasoning of the Supreme People’s Court indicates that it is more likely that a typical VIE contract would be found valid by a court if all of the “safe harbor” conditions are satisfied. Barring a complete elimination by the Foreign Investment Law in the future, such safe harbor can be a powerful tool for foreign-based investors or companies who are seeking financial returns in the Chinese market for their intellectual property rights or products but are less interested in operational control. As most foreign companies do not have the local expertise and resources to operate in China directly, they can use the contractual control and revenue transfer arrangement to delegate the management of its China business to professional management companies located in or outside of China while retaining certain control rights and revenue consolidation. The management company will in turn manage an operating entity in China with necessary licenses and permits that are otherwise unavailable to companies with direct foreign equity control. By having a local management company as the recipient of the control rights and revenue, the transferring mechanism falls squarely under the Ambow Education ruling, and therefore is more likely to be upheld if challenged.
A sample structure of such a safe harbor arrangement is illustrated as follows:
Chinese market has all the reasons to be one of the most attractive markets to internet-based start-ups.
China, with 721 million of online users, remains the largest internet market according to the Broadband Status Report issued by the United Nations Broadband Commission in September 2016. This number of online users is more than 2.5 times the number in the United States. According to a PwC report, the Chinese private equity/venture capital market has grown tremendously in recent years, raising $72.5 billion in 2016, which represents a 49% increase from the previous year. The same PwC report also reports 1,767 Chinese private equity and venture capital-led merger and acquisition deals in 2016 valued at a total of $223 billion, accounting for 73% of the total global PE/VC deal values. Also in 2016, 165 companies went public in China while only 105 IPOs were completed in the U.S. Not only the chance of IPO is higher, the Chinese public market tends to provide higher valuations as compared to its overseas counterparts. From policy perspective, unlike other countries, China treats high-tech startups as a national political priority and allows them access to favorable loans, subsidies and procurement opportunities. The government itself has played a key role of venture capitalist by utilizing government revenue to fund and subsidize startups, as state-owned venture capital funds operates more than $300 billion in assets in various cities and provinces throughout China.
Nevertheless, China remains remote to many start-ups in the Western world. The entire startup ecosystem in China is primarily a self-contained playground with few foreign players participating. Different from other countries, the internet in China operates behind a “Great Firewall” that even internet giants like Google and Facebook have failed to penetrate to date. Operating in China requires numerous licenses and permits that are difficult to obtain for foreign companies with limited resources. As the enormous funds raised by the PE/VCs in China are mostly in RMB, they are also subject to stringent restrictions on outbound investments, hence, those funds remain unknown to start-ups outside China.
Due to the high barrier to entry into the Chinese internet market, most start-ups operate without even having a China strategy in place, which could potentially lead to the loss of tremendous opportunities. The loss sometimes could only be recognized when a similar service pops up and dominates the market before long, sometimes quicker than its U.S. counterpart. It is therefore advisable for each internet-based start-up company to proactively consider and prepare its China strategy upfront.
In order to form your China strategy, it is important to understand the obstacles of entering into the Chinese market.
First, a company has to obtain certain required licenses and permits prior to entering the Chinese internet market legally and many of such licenses and permits are not available to foreign invested U.S. companies.
Although theoretically, Chinese law is inapplicable to foreign internet operators whose operations or servers are based entirely outside China, accessing overseas websites has always been a problem for users within the Great Firewall. The Chinese government recently launched a new campaign to ban unauthorized VPN services in China, further attempting to prevent Chinese internet users from accessing certain internet websites. Various procurement related rules and regulations would also diminish the ability of foreign-hosted services to attract customers in China. Companies interested in obtaining customers from the biggest internet market should therefore take these obstacles into consideration.
The first step is to identify the licenses and permits necessary for your operation in China. The primary regulator of China’s internet infrastructure, the Ministry of Industry and Information Technology (“MIIT”), periodically releases the Classification Catalogue of Telecommunications Services, listing applicable licenses and permits required for basic telecommunications businesses and value added telecommunications businesses. The latest Classification Catalogue of Telecommunications Services, the 2015 Catalogue, covers most internet-based services and products.
Certain MIIT registrations and licenses applicable to internet-based service providers or internet-based product providers are summarized below:
* Foreign invested companies eligible to apply for the above listed permits are subject to additional requirements and sometimes extended processing times.
** The license is generally required if the website or application offers information publication or delivery services, internet search function, community platform, instant information exchange, or information protection and processing services.
It is often confusing as to what specific licenses are needed for certain internet-based service providers, especially with respect to emerging technologies and markets. The Chinese government has issued various rules and regulations to help clarify what is required for specific products and markets. It is recommended that you consult with your legal counsel regarding the specific compliance requirements.
In addition to the licenses issued by the MIIT, certain internet-based services and products are subject to service-specific or product-specific regulations requiring additional licenses and permits, including:
*Simplified approval process applies to certain games that meet the following criteria: (i) game’s copyright is owned by domestic individuals or entities, (ii) the game does not contain any sensitive elements that relate to politics, military, ethnicity or religion, (iii) the game either has no storyline at all or has only a very simple storyline, and (iv) it is in the genre of casual games including match-three, endless runner, top down shooter, board, puzzle, sports, and music, etc.
Overall, it is not an easy task for foreign companies to enter into the Chinese internet market without careful planning. The process to obtain necessary licenses and permits could be so time-consuming that it might take away the technical advantages that the company has in China.
After obtaining necessary permits and licenses, the internet-based companies’ operations are subject to complex compliance requirements.
The permits and licenses issued by the regulatory agencies listed above generally have a limited term that must be renewed before expiration. Certain licenses and permits are also subject to annual inspection. For example, MIIT requires all operators to conduct an annual inspection to ensure compliance with the relevant rules and regulations. The inspection covers all aspects of the operation, including ownership of the entity, business conduct, fees charged to customers, quality of services, cyber security and data privacy measures. Holders of the Online Publishing Service Permits must also submit an annual self-inspection report to SAPPRFT with respect to its compliance and publishing activities. If noncompliance is found to have occurred, licenses and permits may be revoked by the regulating agencies.
Major compliance requirements are summarized below:
a. Cyber security requirements
In November 2016, China promulgated the new Cybersecurity Law, which will take effect in July 2017. The new Cybersecurity Law imposes enhanced security compliance requirements on all “network operators,” which is broadly defined to include all internet service providers. Under existing law, network product providers or network service providers are required to comply with certain national regulations and industrial or local rules. The new Cybersecurity Law will substantially expand the scope of these regulations, making it applicable to cross-industry network operators.
Under the new law, network operators are required to implement cybersecurity measures, including establishing an internal security management policy, designating responsible personnel, adopting technical measures to prevent viruses or cyber-attacks, monitoring network security events, retaining network logs for no less than 6 months, and backing up and encrypting important data and information. As a result, all network providers are subject to complex security classifications and compliance certification processes only previously applicable to information system security products and information technologies used in financial industries. Furthermore, the required security measures may vary based on what impact an operator’s information system will have on national security and the public welfare. For example, providing services in Critical Information Infrastructure (“CII”) areas, such as public communications and information services, energy, transportation, utilities, financial services and governmental affairs, are subject to additional security measures and certifications from the government.
b. Censorship requirements
According to Chinese law, certain information cannot be produced, reproduced, reviewed or transmitted online, including any falsified information, insults or slander, information infringing a third party’s privacy rights or intellectual property rights, information detrimental to governmental credibility, information deemed obscene, or information concerning superstition, gambling, violence, horror, among others. The list is broad and vague without clear guidelines, leaving plenty of room for the government’s interpretation. Under the censorship rules, website operators will be responsible for user postings over which they have no control (such as falsified information and information that infringes another person’s legal rights). For internet-based companies with interactive features and user-provided content, compliance with these censorship rules can be costly and time-consuming, with a high risk of noncompliance.
Additionally, Chinese government agencies may order operators to delete certain information or cease operation in the event that a violation of the censorship rules has occurred. For any violating information hosted outside China, the censorship rules demand that the relevant government agency take technical measures to block the offending site outside the Great Firewall.
c. User verification requirements
The new Cybersecurity Law and other existing laws and regulations require that any network operators require its users to provide identifying information and verify such information before providing network access, domain registration, information publication or instant communication services to such users.
d. Data privacy requirements
Prior to the promulgation of the new Cybersecurity Law, there have already been various government policies, administrative rules, judicial interpretations, and non-binding guidelines relating to data privacy protection. The Cybersecurity Law further provides that network operators must safeguard the confidentiality of personal data collected and the collection and use of such personal data must follow the principles of legality, propriety and necessity. Data collectors must follow the legal requirements in terms of giving notice and obtaining consent. In case of a data breach incident, the data collectors shall report such incidents to the relevant authorities and should also timely notify affected users.
In general, all network operators are required to disclose its privacy policies and obtain consents from users before collecting and using their personal information. Each operator is also required to establish personal information collection and usage safety management policies and designate responsible personnel to safeguard the personal information collected. In case of a leakage or breach, the operator is required to take immediate remedial actions and report to the relevant government agencies.
All network operators are also required to cooperate and provide necessary information to the police or other government agencies to facilitate national security protection or criminal investigations.
e. Data localization requirements
Before the promulgation of the Cybersecurity Law, China had already implemented a number of data localization rules for information collected by financial institutions, medical institutions, cloud computing platforms and data centers providing services to government agencies. The Cybersecurity Law further requires that personal data and important business data generated or collected in China by the operators of CII be stored in China. Transmission of such data abroad will only be allowed if there is an overriding business need and such transfer is approved by the Cyberspace Administration of China or other relevant government agencies after a security assessment.
f. Enforcement mechanism
In addition to monitoring internet activities through government agencies, the Chinese government has also relied heavily on incentivized reporting from online users and self-monitoring mechanisms to ensure compliance. The Cyberspace Administration of China, for example, established a website to encourage web users to report any non-compliance for financial rewards. In January 2017, the reporting center received over 4 million reports of potential violations, and confirmed 2.7 million of such reports. Other government agencies have also set up similar channels to encourage reporting from users on various matters, from the violation of the censorship rules to information leakage. In fact, the Cybersecurity Law requires network operators to set up reporting policies to encourage, collect and process reports from users with respect to any information security matters.
Business issues to consider in forming your China strategy
The Chinese market offers great potential with many new opportunities, but there are also many issues to consider before a company is to enter and navigate this market. Despite of the enormous market size, the booming private equity/venture capital firms in China, and the Chinese government’s generous investment and support to start-up companies, relatively few foreign-based internet start-ups have made their ways to China during their early stages.
Part of the reason can be attributed to high structuring and compliance costs as most internet-based companies have to utilize a special structure called a “variable interest entity” (VIE) to set up contractual control of a stand-alone domestic Chinese entity to circumvent the restrictions on foreign investment. Subsequent to setting up the domestic entity, the filing of relevant IP protections and application processes to obtain the necessary permits in China will be yet another expensive and time-consuming endeavor for internet-based companies.
For example, LinkedIn was founded in December 2002 and went IPO in 2011. Yet, it was not able to enter into the Chinese market until February 2014. Meanwhile, many Chinese domestic start-ups with similar business models such as Lietou.com and Ushi.com established themselves in China during that time. As a latecomer, LinkedIn has had to invest heavily in China to establish its business presence and to catch up to its industry competitors.
A number of U.S. based start-ups with Chinese founders have set up separate entities in China directly owned by these founders or their relatives to help reduce the initial compliance costs in order to conduct their businesses in China legally. Nevertheless, a legally separate Chinese start-up entity with common founders with its U.S. counterpart triggers governance concerns, and usually leads to restructuring down the road which could end up costing more money and frustrating investors.
Even for companies starting up with the customary VIE structure in China, risks remain as the Chinese government has indicated that the structure could be challenged in the future through legislative efforts. The actual equity holders of the operating companies in China, so called nominee stockholders, could claim their equity rights in Chinese courts, and some of such stockholders have prevailed in such claims in the past.
Instead of ignoring the Chinese market entirely, it is advisable for start-ups to consider their China strategy upfront. The key question is how to structure the Chinese operation properly. Before determining your China strategy, a start-up generally needs to consider the following:
- Whether the IP rights critical to your operation can be registered in China to preserve rights even without formally operating in China
Foreign companies are allowed to own patents, trademark and copyrights in China. To preserve your company’s competitive advantage, it is advisable to register your IP properties (e.g., application for patents and registration of copyrights) in China early on even if the company does not plan to enter into the Chinese market in the near future. Such filings will constitute the basis for future collaboration or licensing arrangement in China and protect your IP rights against local competitors. Timing for trademark applications, however, should be treated with some extra precaution, as registered trademarks that have not been used for three consecutive years may be subject to non-use cancellation challenge.
- Regulatory restrictions on foreign investment in your business
China is in the process of opening up more industries to foreign investors although the government’s control in certain areas has been tightening. It is important to understand the regulatory barriers and the timeline for entering into the market before making the ultimate decision on your China strategy. In the case of markets with low regulatory barriers to entry for foreign companies, it is better to start early on before your competitors do so.
- Whether your company’s product can be adopted by Chinese users without significant localization efforts
Certain products are naturally more transferable than the others; for example, cloud-based storage business will be easier to transplant to China than language recognition. If localization is not a big issue for a start-up’s business, it makes more sense to enter into the Chinese market early on.
- The competitive landscape for your product in China versus other countries
As stated earlier, the Chinese market can be a self-contained ecosystem. Many of your competitors might not have been able to penetrate into the market. If your start-up is facing an uphill battle outside China while there are not that many competitors within China, it might be a good idea to shift your battle field.
- The availability of Chinese expertise or partners that you can tap into
To set up an operation in China and establish your own local team to promote your product or business could be difficult for a start-up without Chinese expertise on board. However, many professionals in the field, including local PE/VC specialized in your industry, can provide help. Moreover, it could be a good idea to partner with a local company through a joint venture or a contractual arrangement even if it means certain dilution to your equity position in China.
- Financing or exit options
If some of your existing investors are familiar with the Chinese M&A landscape or capital market, you might consider setting up the company in a way that will make a future exit easier in China. In general, in China, it is much easier to raise funds or exit through strategic acquisitions or IPOs as a Chinese company with foreign subsidiaries than the other way around.
MagStone Law, LLP is pleased to announce that Ms. Bing Zhang Ryan has recently joined the firm as a litigation partner. Ms. Ryan will work out of our Silicon Valley office. Having more than a decade of experience litigating individual and high profile class actions in federal and state courts nationwide, Ms. Ryan has substantial experience in all stages of litigation, including initial case investigation, discovery, and trial. As an instrumental member of several securities and consumer class action litigation teams, she helped her clients obtain favorable settlement results. In an antitrust class action case involving one of the world’s leading manufacturers of Thin Film Transistor -Liquid Crystal Displays, Ms. Ryan successfully persuaded the court in admitting key evidence during the trial and won a favorable jury verdict on behalf of her client.
Prior to joining MagStone Law, Ms. Ryan was a team lead of DLA Piper’s Litigation and Compliance team in China and advised multinational companies on cross-border commercial litigation and government enforcement matters. Her experience includes conducting internal investigations for corporations of different sizes to respond to formal or informal regulatory inquiries from US and Chinese government agencies and to identify employee misconduct.
Ms. Ryan’s extensive litigation and investigation experience helps her develop and implement case strategies during early stages of litigation. She is a frequent speaker on how to mitigate potential risks when running businesses in the US ad in China. She has also helped multinational companies establish adequate internal procedures and policies to avoid potential lawsuits.
Ms. Ryan obtained her Juris Doctor degree from University of California, Berkeley School of Law. Born and educated in China, Bing fully understands the culture sensitivities, reads and writes Chinese fluently, and speaks Chinese in multiple dialects.
“We are delighted to have Bing on board,” says Ruming Liu, a partner at MagStone’s Silicon Valley office. “Her expertise in US litigation and international dispute resolution will allow us to better serve our growing clients and help make MagStone an one-stop full service law firm."
With offices in California and New York, MagStone Law, LLP is a modern law firm dedicated to providing solution-focused and cost-effective high-quality legal services to our clients. MagStone's partners are all experienced lawyers with backgrounds from the most prominent international law firms. Our practice covers all aspects of corporate transactions and litigation. Known for our expertise on China cross-border transactions, we have become the go-to law firm for many Chinese companies exploring the U.S. market.
Increased Governmental Scrutiny
In the past decade or so, the Chinese government has been actively encouraging Chinese businesses to expand globally by acquiring resources, advanced technologies, and distribution channels overseas. Following the relaxation of the outbound investment approval process in late 2014 and early 2015, Chinese direct investment into the U.S. hit a record $45.6 billion in 2016, nearly tripling the amount in 2015 (see figure 1 below), including $36 billion invested by private investors. Despite this surge in the total value of deals in 2016, the total number of completed investment projects by Chinese investors decreased from 169 to 142.
2016 saw a dramatic increase in the average deal value, from $90 million in 2015 to $321 million in 2016. Total investment from the Chinese private companies in the U.S. also increased 202% from 2015 to 2016. Some eye-catching deals included the $6.5 billion acquisition of Strategic Hotels and Resorts, Haier’s $5.4 billion acquisition of GE’s appliance business, the acquisition of Legendary Entertainment for $3.5 billion, Lexmark for $2.5 billion, and Vizio for $2 billion. Some of the transactions involved an unprecedented level of leveraged financing among Chinese buyers.
The dramatic increase in the Chinese interest in U.S. assets caused political concerns in the U.S., especially in the semiconductor industry. In 2016, several deals were either blocked by or abandoned due to the pressure from the Committee on Foreign Investment in the United States (“CFIUS”), including:
Starting from the second half of 2016, it has become clear that the Chinese government is poised to tighten its reins on outbound investments. Many investors started to receive interview requests and the filing process to obtain foreign currency slowed down significantly. In a Q&A statement published in late November 2016, the National Development and Reform Commission (“NDRC”), the Ministry of Commerce (“MOFCOM”), the State Administration of Foreign Exchange (“SAFE”), and the People’s Bank of China (“PBOC”) announced that the following types of offshore M&A transactions are subject to additional governmental scrutiny:
Various local government agencies have also implemented rules restricting capital outflow through overseas acquisitions. Although MOFCOM and NDRC, at the national level, have not implemented any formal rules imposing additional restrictions on foreign acquisitions, the recent actions at local level indicate that all overseas acquisitions going forward must meet the following criteria to complete the registration and currency exchange process:
It is generally expected that NDRC and MOFCOM would promulgate formal rules in the near future to provide legal support for case-by-case reviews of outbound investment transactions.
The Chinese government’s plan to stop outbound capital flight has also included increased scrutiny on exchanges of the RMB. Shortly after the joint statement was published, SAFE announced that any exchange of the RMB in the amount over $5 million would be subject to additional review, versus $50 million in the past. Starting July 1, 2017, PBOC, as the regulator of banks, has also required all financial institutions in China to report any cash transactions over 50,000 RMB (approximately $7,200) or overseas transfers over 200,000 RMB (approximately $29,500). All of those measures will make it more difficult for both individuals and companies to exchange RMB into foreign currencies, regardless of the purpose of such exchanges. In the past, individuals and companies did not face too much regulatory supervision and were generally allowed to purchase under $50,000 in foreign currencies for trade purposes and certain personal uses, such as tourism.
Practical Considerations for U.S. Companies Dealing with Chinese Investors
Many U.S. companies with recent experiences working with potential Chinese investors in M&A deals have shared the same frustration.After several months of conference calls either in the early morning or midnight, the parties finally reach agreements on the commercial terms. The deal seems to be going smoothly until all of a sudden, the Chinese investor calls to say that the promised signing or closing has to be delayed due to some new restrictions on currency exchange. Even if there is a binding agreement in place, a seller probably does not have much recourse under the agreement for the change of law, other than waiting patiently for clarity from the Chinese counterpart on the prospect of closing.
Given the recent uncertainties in this area, we will recommend that a potential seller or target consider the following steps after receiving a call from a potential Chinese buyer expressing interest in your company:
Alternative Means to Finance the Deal
Even if you are in the middle of the process without a finishing line in sight, there are other means to finance the deal despite of the recent governmental scrutiny on outbound investments.
Finally, most analysts believe that the current restrictions are temporary merely aim at preserving China’s foreign currency reserve and discouraging speculative transactions without commercial substance in light of the current economic uncertainties. In the long run, those restrictions could either be modified or lifted when the foreign currency reserve in China or RMB’s exchange rate stabilize.