As many of our readers know, the Regulation on the Administration of Foreign Invested Venture Capital Enterprises (the 2003 VC Regulation) was promulgated on January 30, 2003 and became effective on March 1, 2002. The 2003 VC Regulation superseded the 2001 Tentative Rules on Forming Foreign-Invested Venture Capital Investment Enterprises (the 2001 Tentative Rules). Some commentators heralded the 2003 VC Regulation as a dramatic improvement over the 2001 Tentative Rules. To a certain extent, the 2003 VC Regulation was--and continues to be--a significant incremental step, introducing helpful flexibility in the context of the legal and regulatory regime applicable to foreign investment enterprises. The prevailing view of foreign institutional investors thus far, however, has been similar to that which accompanied the initial 2001 Tentative Rules: in short, progress toward a "best of breed" VC fund framework remains slower than expected.

The landscape isn't all bleak, however. Many of the challenges that need to be overcome in connection with the 2003 VC Regulation relate to purely financial interests of a foreign venture capitalist. While actual cases of fund transactions under the regulations to date are few, a number of investors are in the planning stages of establishing a foreign-invested venture capital enterprise (a VC Enterprise) under the 2003 VC Regulation. We attribute much of this activity to strategic benefits that may be achieved through an on-shore fund structure. For example, reduced approval requirements for investments in portfolio companies available under the 2003 VC Regulation may be more important for securing a local partner with strategic market positioning in the PRC or a key technology than a liquid exit opportunity on an offshore securities market. In addition, local funds may be raised more easily due because RMB-denominated funds may be established. The ability to partner with local investors may also lead to strategic advantages in obtaining first looks at local companies. These and other benefits of the 2003 VC Regulation are beyond the scope of this article. However, note that despite the challenges inherent in the 2003 VC Regulation further described below, certain strategic investors with strategic objectives may find the current environment palatable for establishment of a VC Enterprise.

This article summarizes some of the reasons why reception of the 2003 VC Regulation by much of the venture capital community has been lukewarm. Part I of this article describes certain structural concerns of special interest to venture capitalists that are inherent in the PRC capital markets and corporate law in their current stages of development and reform. Part II discusses specific areas of the 2003 VC Regulation that could be improved, and which arguably, in themselves, are sufficient grounds for a foreign investor's decision to choose an offshore fund structure even for investments in portfolio companies organized or primarily operating in China.

I. Structural/General PRC Market Concerns

As our readers know, foreign investors face many issues venturing into China, including a complex regulatory environment, foreign exchange controls, and the rigidity and early stage of PRC corporate law. This section looks at two structural problems of unique importance to venture capital investors: (1) the dearth of viable exit strategies, primarily due to the relatively illiquid PRC capital markets, and (2) the untested nature of the fund structure that is intended to mimic the key characteristics of a limited partnership, which was established by the 2003 VC Regulation.

The Exit Problem

It goes without saying that the question of "how do I exit?" remains first and foremost in the minds of venture capital investors--particularly financial investors (as opposed to strategic venture funds affiliated with operating businesses). A fundamental feature of the concept of a venture capital fund organized under PRC law is that such a fund would invest in PRC entities. Yet the most prominent examples of exits to date, such as the Nasdaq IPOs of NetEase, Sohu, Sina and AsiaInfo, or eBay's recent US$150 million acquisition of Shanghai's Eachnet, have involved PRC operating entities organized under offshore holding companies.

Current PRC foreign exchange control regulations effectively restrict investment by VC Enterprises to domestic entities. As a result, exit options[fn1] for investments in these entities are effectively limited to the following[fn2]:

• a trade sale of a domestic entity (rather than sale of an offshore holding company)
• a domestic initial public offering of A or B shares on the Shanghai or Shenzhen stock exchange,[fn3] or
• an offering of H shares on the Hong Kong Stock Exchange[fn4]

. In looking at the foregoing options, all are difficult endeavors for a start-up company in China to achieve in practice. A trade sale at the moment is probably the most feasible, but even with the recent promulgation of the new PRC foreign-invested M&A rules[fn5], merger and acquisition activity at the PRC entity level is highly regulated and often subject to multiple approvals. As a result, a sale of the offshore vehicle is sometimes preferable as it is free of many of the constraints of an "onshore" purchase.

A domestic listing on the A or B share market is a similarly difficult feat for start-ups. One reason this may be difficult for start-ups is that the Chinese Securities Regulatory Commission (CSRC) requires a three-year history of profits for a company to be listed on the A or B share market in Shenzhen or Shanghai.[fn6]

Even if a start up qualifies for listing, liquidity remains a significant issue. China lacks a strong base of institutional investors. For example, JP Morgan estimates that less than 1% of all investors in the A share market are institutional investors[fn7]. As a result, the PRC's securities markets are small in comparison to the region's more developed markets. Another feature of the PRC's securities markets that limits liquidity events for investors is the limitation on follow-on offerings: PRC listed companies are permitted to issue new shares only once every 12-months.[fn8]

Finally, even if a start up were to achieve a domestic IPO, and the VC Enterprise investor were able to monetize its investment, foreign exchange repatriation limitations would be an issue for the offshore partners of the fund (see further discussion on this point below).

Start-ups are realistically shut out of H share issues, which have been historically reserved for more mature, in most cases part state-owned or state-controlled, enterprises. Such listings require PRC government approval, and such approval would likely be beyond the reach of most start-ups.

Our experience continues to be that foreign venture capitalists active in China use some form of offshore model for two reasons, both directly related to the question of exits: (1) the sale of the PRC business may be achieved at the offshore level without a transfer of the business, assets or registered capital of the PRC entity, and thus with significantly lower regulatory barriers; and (2) opportunities for the listing of the PRC business are greater if the vehicle to be listed is organized offshore. For example, a Cayman Islands entity could list in Hong Kong or the U.S., or both.

An Untested "Limited Partnership" Form

The 2003 VC Regulation no doubt made great strides in further refining the concept of a "non-legal person" VC Enterprise ("Non-Legal Person VC Enterprise"). A Non-Legal Person VC Enterprise is essentially a form of "cooperative" joint venture, tailored by the 2003 VC Regulation to encompass the features of a limited partnership with which international venture investors are familiar. A Non-Legal Person VC Enterprise may elect either to have all investors bear joint and unlimited liability, or to have one investor bear unlimited liability, with the other investors (similar to limited partners) bearing liability limited to the extent of their investment in the Non-Legal Person VC Enterprise.

The issue for foreign investors is that there is no well-developed body of partnership law in respect of fiduciary duty or other common law issues upon which investors commonly rely in foreign jurisdictions and, therefore, the rights and obligations among the investors in a Non-Legal Person VC Enterprise need to be specified clearly by contract; otherwise, they may not be enforceable by a Chinese court. Moreover, this form is, in effect, a variant of the cooperative joint venture form, which itself has typically been used less frequently by foreign investors because of the extended approval time usually required.

II. Specific Issues

While some improvements to the 2001 Tentative Rules were made in the 2003 VC Regulations, certain issues continue to conflict with what venture capitalists are typically seeking in fund structures. We review these issues in our discussion below, which could be used as a reference "road map" for future changes that may be contemplated by the PRC authorities to the 2003 VC Regulations.

Significant Number of Government Approvals and/or Filings Still Necessary

While certain aspects of PRC government regulation have been significantly streamlined by the 2003 VC Regulation,[fn9] a significant number of filings, regulatory approvals and disclosures are still required. Set forth below are key examples. The following filing or approval requirements of course are in addition to any other approval or filing requirements that the portfolio companies would be subject to:

• In order to establish the VC Enterprise, the application package that is required to be submitted to PRC regulators must consist of, among other things, the following materials:[fn10]
  1. contracts and articles of association of the VC Enterprise signed by all the investors;
  2. a written declaration made by the principal investors, specifying that (a) the investors meet the qualification requirements as provided in Article 7 of the 2003 VC Regulation; (b) all the materials submitted are genuine; and (c) the investors will strictly abide by the present provisions and other relevant Chinese laws and regulations;
  3. a legal opinion stating that (a) each of the principal investors is validly existing and (b) the declaration identified in (2) above has been duly and validly authorized;
  4. information on (a) the venture capital investment operations of the foreign investors, (b) the capital managed by them during the three years prior to the application and (c) the capital actually invested by them during the three years prior to the application, including resumes of the relevant professional venture capital investment managers; and
  5. if the qualifications of the principal investors are based on the qualifications of any of their affiliates, relevant materials of such investors must be submitted indicating that such affiliates meet the statutory qualification requirements.
• The VC Enterprise's "partnership" agreement and any fund management agreements will be subject to PRC government approval.[fn11]
• MOFCOM approval is required for any reduction in committed capital.[fn12]
• Repatriation of capital is subject to a notice and recordation filing requirement, and the VC Enterprise must demonstrate that the balance of the VC Enterprise's committed capital and paid-in capital combined would be sufficient to cover all the outstanding investment obligations. [fn13]

It is important to note that these filings represent a significant additional layer of fund formation work typically not present in a fund raised offshore. Not only do the filings represent a significant layer of additional work, but the entire establishment process is subject to government approval, which in many respects is beyond the control of the sponsors of the fund.

Investments Limited to Equity in PRC Entities

In terms of investment activities, VC Enterprises are permitted only to make equity investments in PRC companies. The 2003 VC Regulation sets forth a rather extensive list of prohibited activities, which include:

• Investment in industries prohibited under the Foreign Investment Industrial Guidance Catalogue
• Direct or indirect investment in publicly traded shares or corporate debt (excluding those of any portfolio company which has gone public)
• Direct or indirect investment in fixed assets not for a VC Enterprise's own use
• Investment through loans
• Investment using other than a VC Enterprise's own funds, and
• Provision of loans or guarantees of loans[fn14]

The foregoing list of prohibited activities affects the foreign investor adversely in a number of ways. First and foremost, the general prohibition on a VC Enterprise's investment in non-domestic entities without approval rules out investment in legitimate PRC businesses with offshore holding company structures. The result is that the VC Enterprise is effectively required to invest its funds in PRC entities with limited listing opportunities, whether domestic or foreign, because of governmental approvals that are very difficult for such entities to obtain.

Another significant issue is that by restricting investment to unlisted companies, one may not operate as a so-called "crossover fund", i.e., a fund that operates partially as a hedge fund and partially as a traditional venture capital fund. Some U.S. funds with this type of flexibility have been able to achieve success during the tech downturn precisely because they were able to take long and short positions with listed companies when the public offering market dried up for venture capital investments.

Participation in Management May Affect Tax Exposure

Much of the tax uncertainty with respect to tax treatment of VC Enterprises under the 2003 VC Regulation has been alleviated due to the promulgation of the June 4 circular (the "Circular") issued by the State Administration of Taxation ("SAT"). [fn15] The SAT confirmed in the Circular that, in the case of a Non-Legal Person VC Fund, investors may elect to be taxed at the enterprise level or separately based upon their individual attributes. This interpretation virtually ensured that the VC Enterprise vehicle could be taxed as a pass-through vehicle, much like a limited partnership.

Notwithstanding the foregoing interpretation of the circular, it is possible that investor participation in investee company management could result in the VC Enterprise being deemed to have a permanent establishment in China. This would give rise to an additional entity-level tax despite the election of the VC Enterprise to be taxed at the partner level. Management participation, particularly at the Board level, is often an important monitoring and control mechanism used by venture capitalists. To the extent board participation results in an increased risk of tax exposure for the VC Enterprise, this would be yet another reason to give foreign investors pause before setting up a PRC fund under the new regulations.

Investors Must Fund Committed Capital Within 5 Years

The 2003 VC Regulation made several important advances beyond the 2001 Tentative Rules in this area. Most notably, the 2003 Regulation does not require that aggregate foreign investment exceed 25% of the total capital in a VC Enterprise, as is otherwise generally required under the Sino-foreign joint venture laws and regulations. [fn16] In addition, the 2003 VC Regulation provides that investors in a VC Enterprise may pay their respective committed capital into the VC Enterprise in installments on an as-needed basis pursuant to the investors' agreement. [fn17] One issue that foreign investors face that would not otherwise arise in an offshore structure is the requirement that they contribute their committed capital within five years (the "Capital Contribution Period"). It appears that the only process by which committed capital may be reduced requires the approval of MOFCOM. Since the maximum life of a VC Enterprise is twelve years, investors may be required to contribute 100% of their committed capital long before actual deployment. A related issue arises if the VC Enterprise sees opportunities to invest beyond the Capital Contribution Period, but funds have been fully deployed. Under the current 2003 VC Regulation, increases in committed capital beyond the Capital Contribution Period of the VC Enterprise would require further government approvals.

Certain Issues Remain Unresolved

Certain issues remain unresolved by the PRC government in respect of the establishment and operation of VC Enterprises. The fact that uncertainty exists with respect to these issues injects yet another element of risk in the VC Enterprise formation process that is likely to cause foreign venture capitalists to be cautious.

For example, the State Administration of Foreign Exchange ("SAFE") has yet to promulgate implementing guidelines with respect to capital repatriation from VC Enterprises. The 2003 VC Regulation gives some guidance on distributions to investors when a Non-Legal Person VC Enterprise disposes of its portfolio investments. Distribution of proceeds from such a disposition is permitted under the regulation, but such disposition results in a reduction of the investors' paid in capital. We note that Article 19(5) of the VC Regulation also suggests, however, that there is a ceiling on remittances of capital out of the PRC. [fn18] The ceiling is equivalent to the investors' original capital contribution. Provision is not made in the 2003 VC Regulation for proceeds in excess of the amount of the original capital contribution.

In addition, while the 2003 VC Regulation clearly identifies certain permitted and prohibited activities, it continues to be unclear whether investment in options, warrants or other convertible securities is permissible. Convertible securities are an important component of the arsenal of investing tools available to investors in offshore jurisdictions. The risk that such tools are not available in the VC Enterprise structure may be problematic from a venture capitalist's point of view.

Until clarification on these and other issues is provided by PRC regulators, the viability of the VC Enterprise structure will remain a question mark for certain foreign venture capitalists.

Conclusion

It is clear that the 2003 VC Regulation improved upon the 2001 Tentative Rules in many respects. However, while some venture capitalists may seize this opportunity to establish funds under the current regulatory environment, continuing systemic inefficiencies present in PRC capital markets, along with certain specific gaps in the 2003 VC Regulation itself, have caused many foreign venture capital investors to continue to use offshore fund structures as vehicles for their PRC investments.

We are optimistic, however, regarding further developments in this interesting and important area.

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Footnotes

1: While Section 34 of the 2003 VC Regulation also provides for share redemption by the investee company as a liquidity option for a VC Enterprise, there is an absence in the PRC corporate law regime regarding the implementation of such redemption. As a result thereof, the share redemption is practically unavailable as a liquidity option for a VC Enterprise, at least for the time being.

2: Of course there are other methods by which Chinese companies have listed shares on overseas markets, but these are limited to companies with offshore structures from inception, such as Netease.com, or pre-1997 "backdoor" listings in which assets of Chinese companies were injected into listed vehicles overseas.

3: "A" shares are issued by domestic companies and are held and traded in RMB by domestic investors, and with the advent of the new Qualified Foreign Institutional Investor regulations, by certain large, foreign institutional investors that obtain PRC government approval (the QFII Regs). "B" shares are issued by domestic companies and are held and traded in foreign currency by foreign investors.

4: "H" shares are issued by domestic companies and listed on the Hong Kong Stock Exchange.

5: Temporary Measures on Foreign Investors Merging with and Acquiring Domestic Enterprises

6: See Article 137 of the Company Law, as amended.

7: See Note 4 above. The QFII Regs are having the effect of increasing foreign institutional investor participation in the A share market.

8: See Article 137 of the Company Law, as amended.

9: For example, the 2003 VC Regulations eliminate the requirement for submission of audited financials as part of the approval package, only require reports to PRC authorities regarding fund raising and fund utilization (as opposed to performance), and permit the admission of new VC Enterprise members and issuance of new VC Enterprise equity interests without additional PRC regulatory approval.

10: Article 9 of the 2003 VC Regulation.

11: Articles 8 and 9 of the 2003 VC Regulation.

12: Article 13(2) of the 2003 VC Regulation.

13: Article 13(5) of the 2003 VC Regulation.

14: Investment in corporate bonds issued by a portfolio company with a maturity of one year or more or loans convertible into equity securities of a portfolio company is permitted.

15: Guoshuifa [2003] No. 61.

16: Article 18 of the Detailed Implementing Rules with Respect to the Sino-Foreign Cooperative Joint Venture Law.

17: Articles 13 and 15 of the 2003 VC Regulation.

18: Article 19(5) of the 2003 VC Regulation.