Key Considerations When Planning FIE Transition Under FIL

This article is the third in our series of articles on the impact of the new Foreign Investment Law (FIL) aimed at assisting companies to navigate the new regime. The new FIL regime has been China’s most significant legislative development in foreign investment in decades. It requires, among other things, existing foreign invested entities (FIEs) to convert their corporate governance structures and adjust other provisions in their joint venture contracts and constitutional documents to comply with the PRC Company Law. The FIL contains a five year transitional period (i.e. by 1 January 2025) to give time for companies to comply. 

In this article, we discuss some of the key considerations in making an FIE transition plan.

Understanding the new regulatory requirements and conducting self-assessment

As a starting point, it is imperative to fully understand the changes that have been made to corporate governance structures under the FIL and the impact of the new regime on the existing shareholder agreements and constitutional documents of companies within your group. Existing FIEs will have been structured in accordance with the decades-old laws governing foreign investments which have become increasingly inconsistent with the PRC Company Law. For example, under the law on Sino-foreign joint ventures, the board of directors functions as its highest authority with board seats allocated in proportion to each joint venture partner’s capital contribution. In addition, certain fundamental matters (such as amending the articles of association, changing the registered capital, or carrying out mergers, demergers, dissolutions or liquidation) require unanimous board approval. By contrast, under the PRC Company Law, the highest authority for a company is its shareholders’ meeting with certain fundamental matters requiring the approval of no less than two-thirds of the voting rights. The PRC Company Law also provides different rules in terms of management nomination provisions and requirements for a supervisory board (or supervisor(s) for a smaller company), more flexibility on profit-sharing mechanisms between or among shareholders and more relaxed conditions on the transfer of joint venture equity interests to third parties.

We recommend that you carry out a careful self-assessment to compare the new FIL regulatory requirements against the articles of association and, if applicable, joint venture contracts of the companies within your group. This will help you identify where any gaps exist and determine how these should be dealt with. Some issues may be purely legal and others will require consideration of a mixture of both legal and commercial aspects needing input from broader business units and internal functions.

Engaging and seeking support from internal stakeholders

Relevant business units and internal functions will need to be fully engaged when planning the FIE transition and during the related document review process. Without internal alignment and support, it will be very difficult for the legal department or outside legal advisors to progress the transition smoothly, particularly in the case of FIEs in the form of joint ventures. It is critical to raise awareness among the relevant internal functions as to the complexities of the FIE transition. The process will require more than simply reviewing the company’s articles of association from a purely legal perspective to bring them in line with the new law. Instead, it should be a joint exercise with input from a business, financial and operational perspective. For instance, the legal team and outside legal advisers will need input from the relevant internal functions to determine the way in which the joint venture contracts and articles of association should be amended. This will be important in respect of aspects such as special approval matters at board/shareholder meetings, procedural requirements for convening these meetings and requirements as to nominations of new director(s) and supervisor(s) and their removal. In joint ventures, the business units are usually closer to the joint venture partners through their daily work and their input will be valuable when planning the FIE transition and in the negotiations (as discussed in more detail below). More often than not, the business units may want certain commercial positions to be reflected in the revised joint venture agreements. They will also have insights as to when and how the joint venture partner should be approached to kick off the transition discussions.

Be prepared to renegotiate with your joint venture partners

We expect that converting existing FIEs in compliance with the PRC Company Law is likely to present a major challenge for joint ventures with a foreign investor as they may have to negotiate with the Chinese partner. While the FIL will have limited impact on wholly foreign-owned enterprises (as their organisational form and corporate structure have been governed by the PRC Company Law since 2006), it will have a major impact on existing joint ventures. Converting their corporate governance structures will involve changes to, among other things, the decision-making mechanism, voting, quorum and management nomination provisions, which will likely open the door for renegotiation and could have a major impact on the dynamics of the relationship between the joint venture partners.

You should evaluate your position in your existing joint ventures and prepare yourself for the changing landscape. In particular, be aware that a foreign investor may no longer have veto rights by law if it is a minority shareholder in a joint venture. Alternative voting mechanisms that are consistent with the PRC Company Law will need to be designed and matters that must be approved by the minority shareholder may need to be negotiated. However, in the case of a 50/50 or 51/49 joint venture, we expect that there will be less impact on the decision making power dynamics. This is because important matters will still need to be approved by shareholder(s) representing no less than two-thirds of the voting rights as required by the PRC Company Law, meaning that each of the joint venture partners will still have veto rights over these matters. In addition, you may wish to consider whether there are any legacy issue you would like to take the opportunity to resolve and, on the other hand, to anticipate whether there are any commercial or other governance issues that your JV partner is likely to raise during the negotiation.

Time is of essence despite the five-year transitional period

The FIL requires that, within the five-year transitional period, existing FIEs must reform their corporate governance structures to comply with the PRC Company Law. The implementation regulations further provide that, after the expiry of the transitional period (i.e. from 1 January 2025), if an FIE fails to convert its corporate governance structures, the company registration authority will reject any registrations by the FIE and will publicise its non-compliance in the China’s National Enterprise Credit Information Publicity System. In practice, company registration authorities in some localities have begun reminding companies to review and revise their articles of associations and/or joint venture contract against the Company Law when they file applications for change of company registration records, although such revision is not mandatory until the expiry of the transitional period.

Five years seems like a long time. However, given the complexities of the transition exercise and the attitude of the company registration authorities as discussed above, we strongly recommend that foreign investors start preparing as early as possible to ensure sufficient lead time for legal analysis, internal alignment, renegotiation, document preparation and filing formalities.

It is also important to note that there is no five-year transitional period for new foreign investments, whether by way of greenfield investment or mergers and acquisitions. The new FIL applies to all such new foreign investments unless they were completed before the end of 2019.

KEY CONTACTS

Nanda Lau 刘依兰

Head of Shanghai Office

Nanda.Lau@hsf.com

Gavin Guo 郭武汉

International Partner

Kewei (Shanghai)

Gavin.Guo@hsfkewei.com

Angela Zhao 赵秋丹

Senior Associate, Shanghai

Angela.Zhao@hsf.com

Patrick Han 韩谷乔

Senior Associate, Shanghai

Patrick.Han@hsf.com

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