China expands the scope of its existing national security review regime
On 19 December 2020, China’s National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM) jointly adopted “upgraded” rules for conducting national security review (NSR) of foreign investments. The new rules, Measures on Security Review of Foreign Investment (New Measures), take effect from 18 January 2021.
China established its NSR regime in 2011 (the 2011 Rules) but rarely enforced it until last year, when NDRC replaced MOFCOM as lead coordinator of the inter-ministerial committee that conducts NSR reviews. Since then, NDRC has called in a number of transactions for NSR review, often triggered by third party complaints and such reviews have sometimes led to companies abandoning a transaction. For example, in late 2019, Jardine Matheson-backed Yonghui Superstores abandoned its proposed acquisition of a controlling stake in Zhongbai Holdings, a Chinese state-owned supermarket operator, reportedly due to concerns raised by NDRC during the NSR process. The transaction had already been reviewed and approved for merger control purposes.
These New Measures provide clarity on NDRC’s approach to the NSR regime. Compared with the 2011 Rules, the New Measures:
a) expand the type of transactions subject to the NSR regime, to capture not only direct M&A activity, but also indirect foreign investments and greenfield investments, in line with China’s new Foreign Investment Law which entered into effect earlier this year;
b) expand the sectors subject to the NSR regime to include critical cultural, IT-related, and Internet products/services and critical financial services; and
c) streamline the previous procedural rules, but also potentially introduce longer review periods, for example by allowing the authority to “stop the clock” when companies are responding to the authority’s information requests or to extend the review period in unspecified circumstances.
As China continues to shorten its Negative List (which lists sectors where foreign investment is prohibited or restricted)* and opens its domestic market to foreign investment, we expect the NSR regime to play a more prominent role in the future. Below is a summary of the New Measures. We would be happy to discuss this further with you if you have any questions.
1. How is “foreign investment” defined under the New Measures?
An investor is deemed a foreign investor if the investor is not Chinese or is not incorporated in China. For the purposes of the NSR regime, Hong Kong, Macau and Taiwan investors are considered as foreign investors.
Under the 2011 Rules, the NSR regime mainly captured a foreign investor’s merger with or acquisition of domestic non-foreign-invested enterprises. In line with the new Foreign Investment Law (effective since 1 January 2020), the New Measures expand the scope of captured foreign investments to include both direct and indirect investments, in the form of M&A, greenfield investments (both wholly-owned projects and joint ventures) and investments through other means (potentially capturing an acquisition through contractual means, such as a VIE arrangement). Under the New Measures, an indirect acquisition of a domestic enterprise already owned by foreign investors (for example, as a result of a pure offshore transaction) can also be subject to the NSR regime.
2. What is the scope of foreign investment subject to the NSR regime?
Under the New Measures, the NSR regime applies to:
- investments in military or military-related industries, or investments located near military facilities; or
- acquisition of control over a Chinese target active in critical agriculture, critical energy and resources, significant equipment manufacturing, critical infrastructure, critical transportation services, critical cultural products and services, critical IT-related or Internet products and services, critical financial services, key technologies and other critical sectors. The exact scope of such critical, key or significant sectors remains unclear and is to be tested in practice.
The New Measures expand the scope of sectors subject to the NSR regime to include critical cultural, IT-related, or Internet products/services and critical financial services. Furthermore, they include a catch-all clause, which gives the authority broad discretion to further expand the scope of transactions subject to the NSR regime.
The foreign investor(s) will be deemed to have acquired control where the foreign investor(s):
- holds 50% or more of target’s shares post-transaction;
- holds less than 50% of target’s shares, but has sufficient voting rights to materially influence resolutions of shareholders’ meetings and board of directors; or
- can exercise material influence over key matters such as business decisions, personnel, finances, and technology through other means.
3. Which authority will enforce the NSR regime and how will the NSR process be initiated?
The New Measures establish a so-called “working mechanism” to implement the NSR regime, with its office located at NDRC (the Office). The “working mechanism” is akin to the previous “inter-ministerial committee” under the 2011 Rules and includes NDRC, MOFCOM and other relevant sector regulators.
If a transaction falls under the NSR regime, foreign investors are obliged to submit a NSR filing to the Office. The New Measures make clear that the NSR regime is mandatory and suspensory and an investment caught by the regime must not be implemented without the authority’s prior approval.
The Office also has ex officio powers and may require the foreign investor to submit an NSR filing, even if the transaction has already closed. In addition, any third party can ask the authority to initiate a NSR process, which appears to have been the main trigger for NDRC calling in recent transactions for NSR review.
4. What are the standards of review?
The New Measures are silent on the applicable standard of review, but the 2011 Rules (which have not yet been repealed yet) provide a review standard at a high level. This include, for example, whether the underlying transaction will impact national defense and security, national economy, social order or R&D capabilities for core technologies relevant to national security. It is anticipated that the New Measures may apply similar standards.
5. What are the procedures applicable to a NSR filing?
The New Measures streamline the previous procedural rules, but are likely to introduce longer review periods. Under the New Measures, the authority’s review of a NSR filing can be conducted in three stages:
- Preliminary review to determine whether a foreign investment falls under the NSR regime must be completed within 15 business days.
- General review must be completed within 30 business days if a foreign investment is subject to the NSR regime and raises no issues. Transactions with potential concerns may be subject to a special review period.
- Special review must be completed within 60 business days but can be extended in special scenarios. A “special scenario” is not defined and there are no statutory time limits for extending the review period.
The New Measures also introduce a “stop-the-clock” mechanism. This enables the authority to stop the clock as it awaits a foreign investor’s responses to information requests. Foreign investors will need to address the authority’s requests promptly in order to advance the review process.
6. What are the possible outcomes following a NSR filing?
As with the 2011 Rules, in addition to unconditional clearance and prohibition, the Office can also clear a transaction subject to conditions. Although it remains unclear what types of remedies will be acceptable in a given case, both structural and behavioural conditions may be explored if a foreign investment in China attracts national security concerns. For example, NDRC reportedly called in Diodes Incorporated’s acquisition of Lite-On Semiconductor for NSR review. According to public sources, the Taiwan-based target eventually sold its controlling stake in a Chinese subsidiary before the parties received both merger control and NSR approval. It is unclear if the divesture was requested by the Chinese authorities or proposed by the parties proactively to facilitate the review process.
7. What are the consequences for non-compliance?
While there is no monetary fine for not making a NSR filing, the New Measures introduce a set of measures that govern situations where a foreign investor refuses to file if requested to do so, fails to respect remedies imposed or submits false information. The Office may ask the foreign investor to take any necessary actions to address the identified national security concerns, including but not limited to divestiture of the acquired shares or assets. Furthermore, non-compliance will be recorded in the national credit information system and may be subject to disciplinary action. This could have a negative impact on the daily operations of the companies concerned.
*As China continues to open up to foreign investment, the list has reduced from more than 70 sectors 5 years ago to 33 sectors currently.