On 3 February 2011, the State Council promulgated the “Notice of the General Office of the State Council on Launching the Security Review Mechanism for Mergers and Acquisition of Domestic Enterprise by Foreign Investors” (the Notice), which established the national security review system for merger and acquisition (M&A) transactions by foreign investors in China. On 25 August 2011, after a trial period of about six months of an interim regulation on the security review system, on 25 August 2011, the Ministry of Commerce (MOFCOM) finalised and issued the “Regulation on Implementing of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors” (the Regulation), which came into effect 1 September 2011. The national security review system as established and specified under the Notice and the Regulation may have a broad impact on prospective foreign M&A transactions in China.
Scope of Review
An M&A of Chinese enterprise by foreign investors in China shall go through security review if foreign investors take de facto control (see De Facto Control section below) of the Chinese enterprise and the Chinese enterprise is:
- A military or military-related enterprise surrounding a key or sensitive military infrastructure or a unit otherwise related to the military
- A national security-related enterprise regarding an important agricultural product, important energy and resource, important infrastructure, important transportation, key technology or major equipment manufacturing
However, there is no further definition under the Notice and Regulation regarding terms such as important agricultural product, important energy and resource, important infrastructure, important transportation and key technology. Thus, the review scope is still ambiguous and foreign investors may consider having a pre-application consultation with the competent review authorities.
M&A of Domestic Chinese Enterprise by Foreign Investors
M&A of a domestic Chinese enterprise by foreign investors is defined as any one of the following:
- A foreign investor purchases the equity interests of a Chinese enterprise or subscribes to the increased capital of a Chinese enterprise
- A foreign investor purchases the equity interests of a Chinese shareholder of a foreign-invested enterprise (FIE) in China or subscribes to the increased capital of an FIE
- A foreign investor sets up an FIE and uses it to purchase and operate the assets of a Chinese enterprise, or uses the FIE to purchase the equity interests of a Chinese enterprise
- A foreign investor directly purchases the assets of a Chinese enterprise, and sets up an FIE in use of the assets, which then operates on the assets
De facto Control
De facto control of a Chinese enterprise by a foreign enterprise refers to the foreign investor becoming a controlling shareholder or a de facto controller of the Chinese enterprise via the M&A transaction in question, which includes:
- A foreign investor, its controlling parent company and/or its controlled subsidiary taking more than 50 per cent of the equity interests of the merged or acquired Chinese enterprise
- Several foreign investors cumulatively taking more than 50 per cent of the equity interests of the merged or acquired Chinese enterprise
- A foreign investor having a major influence over the decision of the meeting of the shareholders or the board of directors of the merged or acquired enterprise although the foreign investor acquires less than 50 percent of the equity interests of the merged or acquired Chinese enterprise
- A foreign investor taking de facto control over business decision-making, finance, human resource or technology of the merged or acquired Chinese enterprise
Factors to Consider on National Security
- Influence of the M&A transaction over national defence (including capacity of manufacturing domestic products, providing domestic services or providing the facilities and equipments in question for national defence)
- Influence of the M&A transaction over the stable running of China’s economy
- Influence of the M&A transaction over basic social life and order
- Influence of the M&A transaction over research and development of key technology regarding national security
Initiation of Security Review
- Any foreign investor involved in an M&A transaction that falls within the scope of review under the Notice shall file an application for review with MOFCOM.
- If a competent local MOFCOM authority, during its examination of an M&A transaction application, considers the M&A transaction subject to security review, such authority will suspend its examination, report it to MOFCOM and issue a written notice requiring the foreign investor to file an application with MOFCOM.
- Competent government departments, national industrial association, competitors and upstream and downstream enterprises that consider it necessary for an M&A transaction to be subject to security review may also suggest a security review with MOFCOM.
Pre-Review Consultation Mechanism
Before formally submitting a security review application, foreign investors may file an application with MOFCOM to consult on procedural issues regarding the intended M&A transaction and to communicate relevant conditions. However, such pre-review communications are not legally binding.
Review Application Documents
Summarized below are some basic documents that shall be filed with MOFCOM for a security review application:
- Duly signed application letter and transaction statement
- Notarised and legalised ID documents or certificate of incorporation of the foreign investors and letter of creditworthiness
- Fact Statement, Articles of Association, Business License, audited financial reports of the previous year, diagram of organizational structure before and after M&A of the merged or acquired Chinese company and conditions of its investing companies
- Joint Venture Contract, Articles of Association, appointment letters of directors, list of management and officials of the intended newly established company upon completion of the M&A transaction
- For M&A transaction by share transfer, share transfer agreement (or subscription agreement for capital increase), approval resolution of shareholders of the merged or acquired company and assets evaluation report
- For M&A transaction by assets transfer, assets purchase agreement (including list and status of assets to be purchased), approval resolution and assets evaluation report
- Foreign investors’ voting power’s impact on resolution of shareholders’ meeting and board of directors upon completion of the M&A transaction, statements about other conditions to cause change of de facto control over business decision-making, finance, human resource or technology to foreign investors, and related agreements or documents
- Other documents MOFCOM may require
- An inter-ministry roundtable conference (the Conference) is established to conduct the security review.
- Under the leadership of the State Council, the Conference is jointly initiated by the National Development Reform Conference and MOFCOM involving the ministry of the industry related to the M&A transaction under review.
- The Conference shall analyse the influence of the M&A transaction over the national security of China, conduct research on the major national security issues and resolve the issues, review the M&A and make its decision.
- The review application shall be filed by foreign investor(s) with MOFCOM. In the case of several foreign investors, it can be filed by them jointly or through one representative. MOFCOM will give written notice upon its receipt of the application documents. The review application will be forwarded to the Conference within five business days if the M&A transaction under consideration is deemed by MOFCOM to fall in the review scope.
- The Conference will conduct a general review first, i.e., to solicit written opinions from the relevant authorities, whereupon they have 20 business days to give their opinions. In the case where no national security impact is found, the Conference will notify MOFCOM of the result. MOFCOM will then notify the applicant within five business days and the suspended examination and approval formalities can be resumed. However, if a relevant authority finds the M&A transaction may impact national security, the Conference will initiate a special review within five business days upon its receipt of the opinion.
- In the event of special review, the Conference will organise security evaluation on the M&A transaction and will have 60 business days to issue the approval, disapproval or approval conditioned on the parties taking specified remedial actions. In the case that there is a major discrepancy among the members of the Conference, the Conference shall report the review to the State Council for its decision, which will take a longer time.
- The parties to the M&A under the review shall co-operate with the work of the Conference in conducting the review by submitting materials and information that are necessary for the review, and answer inquiries by the Conference.
- An applicant for a review may apply to alter or withdraw from the M&A transaction under review.
- The Conference shall ask MOFCOM and the concerned agency to terminate an M&A transaction if the deal has impacted or may have an impact on national security; or divest the concerned equity interests or assets or adopt some other effective measures to offset the impact on national security.
Article 9 of the Regulation provides that the issue of whether an M&A transaction by foreign investors falls into the scope of security review shall be judged based on the substantial content and actual impact of the transaction. Foreign investors shall not circumvent the security review by any means, including, but not limited to, nominee shareholdings, trust, multi-tier re-investment, leasing, loan, contractual control and offshore transactions.
The term “contractual control” is not defined under the Notice and the Regulation. Generally speaking, contractual control refers to actual control over business decision-making, finance and various major aspects of a target company through a series of contractual arrangements rather than holding equity interests of the target company. In practice, contractual control has been adopted in many industries, which normally is reached between a wholly foreign-owned enterprise and a domestic Chinese company. The controlled Chinese company is called a variable interest entity and such a business model is referred to as “VIE Mode”, which, to a certain extent, can circumvent some restrictive rules and policies concerning foreign investments. However, due to the express non-circumvention provision of the Regulation, if an M&A transaction by foreign investors that intends to adopt the VIE Mode falls into the scope of review, the transaction structure needs also to be disclosed to the authorities for its review.
The Notice and the Regulation also apply to investors from Hong Kong, Taiwan and Macao.
The national security review system was formalised earlier this year. The competent authorities have not made public any information about any transactions reviewed, thus it is difficult to gauge the impact of the Regulation on prospective M&A transactions by foreign investors in China. Still, foreign investors may consider retaining professionals to conduct pre-review consultation and communications with MOFCOM to understand whether the intended M&A transaction falls into the scope of review as well as other concerns, although the pre-review consultation mechanism with MOFCOM under the Regulation only relates to procedural issues.
MWE China Law Offices will keep abreast of the development regarding the new rules and cases on the national security review, and provide analysis in a timely manner.