MoFo PE Briefing Room
China’s new foreign investment regime introduced by the Foreign Investment Law (“FIL”) and its implementation rules, which came into effect on January 1, 2020, should allow PE funds to invest in Chinese domestic companies on terms that more closely resemble international standard terms.
Pre-2020, PE investors desiring to do deals in China relied on creative arrangements in joint venture contracts to secure their “preferential” rights onshore. Although the FIL still only provides for one class of equity, and thus PE investors in domestic companies will not be permitted to hold preferred equity per se, some preferential rights are permitted.
The FIL permits a distribution waterfall that would allow dividends preferentially distributed to PE investors as negotiated among the shareholders instead of in proportion to their respective contribution. On the other hand, under the new regime, negotiated liquidation preference not in proportion to the shareholders’ respective contribution, which was explicitly permitted for Chinese foreign invested enterprises (“FIE”) under the old regime, may face challenges in practice, because the FIEs are now subject to the same laws applicable to domestic companies where distribution of assets in a liquidation event shall be in proportion to contribution by the shareholders, and if the FIE and other shareholders refuse to honor the negotiated terms of liquidation preference, it is uncertain whether the court will decide in favor of the PE investors to enforce their contractual liquidation preference right. As for other “deemed liquidation events” outside of winding up proceedings, the situation differs depending on the structure of the deal. For a sale of the company structured as an equity deal, generally the liquidation preference as negotiated would be honored. However, for a sale of all or substantially all assets of an FIE where such FIE itself needs to pay shareholders the proceeds, liquidation preference is enforceable only if the company has sufficient profits after paying statutory liabilities. Otherwise, the FIE needs to obtain at least two-thirds of total voting rights to reduce its registered capital first.
It remains practically difficult for PE investors to enforce a redemption right that would require the cooperation of the other shareholders, including a vote by shareholders holding at least two-thirds of the voting power to approve the capital reduction and amendment of the articles of association and the procedural process to be completed by the FIE. On the other hand, a put right, which allows PE investors to sell their equity to other shareholders at a pre-determined price and upon the occurrence of specific events, is generally enforceable.
Under the pre-2020 regime, the consent of all non-selling shareholders was required for a shareholder to transfer its equities in an FIE, subject further to the right of first refusal of the non-selling shareholders. Under the new regime, a PE investor could transfer without consent of other shareholders if it followed pre-agreed transfer procedures and, absent pre-agreed transfer procedures, any transfer to non-existing shareholders is subject to the consent by more than half of the non-selling shareholders, and any non-selling shareholder that does not consent to the transfer and refuses to buy the equity to be transferred is deemed to have consented to the transfer. In addition, the fact that no Ministry of Commerce (“MOFCOM”) approval will be required for transfer of equity in an FIE (as long as the FIE does not operate in a sector on the negative list) is beneficial to PE investors: In the past, controlling shareholders sometimes used their connections at MOFCOM to thwart a transfer with which they disagreed. The absence of the approval requirement will make transfer rights more easily enforceable.
The highest authority of an FIE will no longer be the board of directors, as was the case under the pre-2020 regime. Instead, matters that are generally subject to shareholder approval in other jurisdictions (such as amendment of constitutional documents, change of registered capital, merger, spin-off, and dissolution) will require the approval of shareholders holding two-thirds of the equity of the FIE, subject to any veto rights as may be agreed among the shareholders. There will no longer be any matters that, according to the law, require the unanimous approval of the board of directors or the shareholders.
The old days of multiple governmental approvals for the establishment of, and transfer of equity of, an FIE seems to be gone. MOFCOM will only monitor foreign investment through the information reporting system, and it will not be necessary to obtain MOFCOM approval for the joint venture contract (or other investment documents) of, or the transfer of equity of, an FIE. This opens the door for more internationally standard investment documents being used for investments in FIEs rather than documents based on the form to which MOFCOM was accustomed and thus would more readily approve. Note that if an FIE operates in a sector that is on the negative list, approvals are required.
An FIE is no longer subject to a foreign debt ceiling that must be linked to the difference between the amount of its registered capital and total investment. An FIE can choose the debt ceiling applicable to domestic companies, currently two times the net assets of the FIE. It remains unclear whether the historical link to the difference between the amount of registered capital and total investment will be abolished. PE investors and their portfolio companies may structure deals such that FIEs use the same financing methods available to domestic companies, including public offering of shares, bonds, and other security or debt instruments. Further, PE investors may use shares in offshore listed companies or overseas special-purpose vehicles as in-kind consideration to acquire equities in domestic companies.
There are a number of additional provisions in the FIL that generally give PE investors more comfort when it comes to evaluating business plans or onshore bolt-on opportunities for their portfolio companies, though their specific impact, if any, on foreign investments remains to be seen. For example:
China still needs to do a lot of work to convince the outside world that it is committed to offering a transparent and accountable market to foreign investors. The market will closely monitor all subsequent measures issued by the regulators on this topic. It remains to be seen how comfortable local shareholders and partners will be with PE investors seeking to negotiate terms more customarily accepted by offshore players. Morrison & Foerster will continue to monitor these developments and keep our clients informed.
* Morrison & Foerster Trainee Solicitor Wyatt Zhang assisted in the preparation of this client alert.