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State Council Announces New Security Review Regime for Foreign M&A Transactions in China

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Victor Ho

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17 February 2011

On 12 February 2011, the General Office of the State Council of the PRC published a notice (the Notice) establishing a new regime for the "security review" of mergers and acquisitions by foreign investors of domestic Chinese companies.

The Notice provides for the creation of a new "Interdepartmental Committee", overseen by the State Council and under the leadership of the National Development and Reform Commission and the Ministry of Commerce (MOFCOM), which will be tasked with reviewing certain M&A transactions by foreign investors of Chinese companies active in certain sensitive sectors on "national security" grounds.

The Notice sets out a broad range of industries covered by the security review regime, which include important agricultural commodities, important energy and natural resources, important transportation services, critical technology and significant equipment manufacturing. The Notice also contains a very broad statement of the factors to be taken into account by the Interdepartmental Committee in its conduct of security reviews.

Since 2006, MOFCOM has had express powers to review and terminate transactions which may impact the economic security of the state. As such, the principles underlying the Notice are not new. Given the importance of foreign investment to the continued development of the Chinese economy, we do not expect the Notice to be a catalyst for a material change in approach by the PRC authorities to foreign investment. However, the Notice does raise a number of questions and concerns for foreign investors in China, and will potentially increase execution risk and lengthen the time required to close transactions in China.

In this e-Bulletin, we set out the major features of the new security review regime as established in the Notice, drawing particular attention to areas of concern for foreign investors.

[1] The original Notice (国务院办公厅关于建立外国投资者并购境内企业审查制度的通知) can be found at An unofficial English translation of the Notice ("Notice of the General Office of the State Council concerning Security Review of Mergers and Acquisitions of Domestic Enterprises by Foreign Investors"), prepared by Allen & Overy, LLP, is available on request.

The scope of the M&A transactions falling within the scope of the security review regime

The Notice applies to "mergers and acquisitions of domestic enterprises by foreign investors," which is defined to encompass the following (seemingly exhaustive) list of transactions (Transactions):

  • the purchase of shares in, or subscription to the capital increase of, a wholly domestic-owned enterprise by a foreign investor (such that the domestic enterprise is converted into a foreign-invested enterprise);
  • the purchase of the shares of the Chinese party in a foreign-invested domestic enterprise by a foreign investor, or the subscription by a foreign investor to the capital increase of a foreign-invested domestic enterprise;
  • the establishment of a foreign-invested domestic enterprise by a foreign investor, who thereafter (i) enters into an agreement via that foreign-invested domestic enterprise to purchase the assets of a domestic enterprise and starts operating those assets, or (ii) purchases the shares of a domestic enterprise in the name of that foreign-invested domestic enterprise; and
  • the direct purchase by a foreign investor of the assets of a domestic enterprise, which assets are then used to invest in and establish a foreign-invested enterprise for the operation of those assets.

Elsewhere, the Notice defines "foreign investors" to include investors in Hong Kong SAR, Macau SAR and Taiwan.

Excluded transactions

It is debatable whether the Notice covers:

  • the sale of shares in a foreign-invested domestic enterprise by one foreign investor to another where the overall foreign shareholding percentage in the domestic enterprise remains unchanged; or
  • traditional "green-field investment", at least insofar as such investment is conducted without the acquisition of the assets of a domestic enterprise.

Industry sectors falling within the scope of the security review regime

The security review regime established by the Notice applies to Transactions falling into two broad categories:

  • Transactions by foreign investors involving domestic enterprises engaged in military and defence-related businesses, including military industrial companies (and companies ancillary to them), companies located near military facilities, and other enterprises and institutions "relating to" national defence and security; and
  • Transactions by foreign investors in certain sectors "relating to national security", where the foreign investor obtains actual control over the enterprise in question. The sectors listed are: important agricultural commodities, important energy resources and natural resources, important infrastructure, important transportation services, critical technology and significant equipment manufacturing.

Acquisition of control

The system for security review established in the Notice is effectively a two-tier regime: all Transactions in core military and defence-related industries will be subject to security review; on the other hand, Transactions involving domestic enterprises operating in that more nebulous area "relating to national security" will only be subject to review if the foreign investor obtains actual control of the domestic enterprise as a result of the Transaction.

"Actual control" includes shareholding control and also de facto control (e.g., where the foreign investor is able to exercise significant influence over the resolutions of the shareholders' meeting or board of directors of the domestic company, or otherwise control the business strategy, finances, human resources and technology of the domestic enterprise). The test of de facto control under the Notice is seemingly broader than the test that applies in the merger control context under the AML, which emphasises "decisive influence".

Wide scope for review

The indeterminate nature of the various industries listed, as well as the concept of "national security", gives the PRC authorities wide discretion to subject relevant Transactions in China to an additional layer of administrative scrutiny. This conclusion is only reinforced when one examines the factors that the Interdepartmental Committee is to take into account when conducting a "security review". These include the effect of the Transaction on national defence and security (e.g. the impact upon the domestic manufacturing capability for commodities and equipment/facilities required in national defence and the domestic capacity for the provision of services required in national defence), and also a far broader set of objectives, including the "stable operation of the national economy", the "fundamental social order," and the effect of the Transaction on China's R&D capability in respect of vital technologies relating to national security.

With relevant factors framed in such a broad manner, the potential for the Interdepartmental Committee's review to stray into questions regarding the competiveness and strength of domestic enterprises vis-à-vis foreign investors is clear.

The procedures for the review of a relevant Transaction by the Interdepartmental Committee

There are effectively two channels for a security review to be initiated:

  • the Notice implies that foreign investors are obliged to apply to MOFCOM for the conduct of a security review when involved in a Transaction that falls within the scope of the Notice; and
  • the Notice further provides that a range of third parties not involved in the Transaction can apply to MOFCOM for a security review to be initiated, including related departments of the State Council, industrial associations, and enterprises engaged in the same industry (including upstream and downstream industries).

The conduct of a security review by the Interdepartmental Committee will be automatic in the first case and dependant in the second case on the decision of the Interdepartmental Committee.

Once initiated, the security review process consists of two potential stages, with the first stage lasting up to 40 working days and the second stage lasting up to a further 60 working days:

  • the first stage, referred to as "general review", involves the Interdepartmental Committee soliciting written submissions from other governmental departments. These governmental departments (which are not specifically identified in the Notice) will then have 20 working days from their receipt of the Interdepartmental Committee's request to present their submissions on the proposed Transaction. If the relevant government departments are all of the view that the Transaction will not affect national security, then the security review process comes to a close with the Interdepartmental Committee advising MOFCOM of the review decision within five working days of its receipt of all submissions from the government departments;
  • if some or all of the relevant government departments consider that the Transaction is likely to affect national security, the Interdepartmental Committee must initiate a second stage of review (referred to as "special review") within five working days of its receipt of all submissions from the relevant government departments. Although the Notice is somewhat vague as to how a "special review" will be coordinated, it appears that the Interdepartmental Committee will collect the views of its various stakeholders or members and seek a consensus as to whether to clear the Transaction. If the Interdepartmental Committee is able to reach consensus internally, it will submit its findings to MOFCOM for announcement to the parties. If, on the other hand, no consensus can be reached, the matter will be transferred for decision by the State Council. The Interdepartmental Committee has 60 days from the initiation of the special review to either inform MOFCOM of its decision or transfer the matter to the State Council. It is unclear whether any time limit applies where the review is transferred to the State Council. MOFCOM is responsible for informing the applicants of the final review decision, and it is further unclear whether any time limit applies here.

No express right for parties to the Transaction to participate in the security review

There is no provision in the Notice for the participation in the review process by the parties to the Transaction. The Notice does not provide for any pre-Transaction consultation procedure with either the Interdepartmental Committee or MOFCOM, and, once the security review process is underway, the security review will become an internal matter for the government authorities.

Relationship with other investment approvals

The Notice also offers no guidance as to how the security review process is to interact with other foreign investment review procedures. Presumably, the new security review regime is additional to any existing approvals, and does not displace the need for other investment approvals, including those conducted by MOFCOM at the local or central level (including the merger review process administered by MOFCOM at the central level).

Possible outcomes of the security review

To the extent that the relevant Transaction has not closed, the outcome of the security review process would presumably either be an order that the Transaction not proceed or a simple approval notice (though this is not expressly stated in the Notice).

The Notice does provide that the applicants can suggest revisions to the planned Transaction during the course of review, or agree to rescind the Transaction. The former option suggests something akin to MOFCOM's imposition of "restrictive conditions" in the anti-trust context, with the parties to the Transaction agreeing with MOFCOM to amend the structure of the Transaction.

Retroactive Power

More importantly, however, the Notice further provides that where the Interdepartmental Committee considers that a foreign investor's merger or acquisition of a domestic company has already had a significant effect on national security, or is likely to have such an effect, it should instruct MOFCOM to coordinate with other relevant government departments to terminate the Transaction, or adopt such other measures as are necessary to eliminate the perceived effect on national security, such as forcibly transferring the shares in the company to another party. This additional provision appears to suggest that the security review regime will operate not merely as a hurdle for prospective Transactions, but might also operate retrospectively, unwinding Transactions previously approved and implemented by foreign investors in China.

The Notice enters into effect on 5 March 2011.