What’s Missing in China’s Foreign Investment Law?

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What’s Missing in China’s Foreign Investment Law?

‘‘The law and its implementing regulation still lack implementation details on how to protect the legitimate rights and interests of foreign investors.’’

What’s Missing in China’s Foreign Investment Law?

For many decades, foreign companies operating in China complained about unfair trade and investment practices. The recent introduction of the Foreign Investment Law (FIL) signals that those concerns are now being taken more seriously. The law promises to ban forced technology transfers, protect intellectual property, and allow foreign businesses to compete more fairly.

Alberto Vettoretti, managing partner at Dezan Shira & Associates, notes that it remains to be seen to what extent regulations can be effectively implemented in practice and expects the adoption of new amendments to address many of the uncertainties associated with the law. In this interview, he details what the law is missing and suggests where improvements can be made.

Maurits Elen: What are the most important changes in the FIL?

Alberto Vettoretti: In a broad sense, one of the most fundamental changes introduced by the FIL is that it now unifies the treatment of investments made by all types of foreign enterprises and allows them to participate in market competition on an equal basis.

Before the FIL, there were three laws regulating three types of foreign enterprises, namely: wholly foreign owned enterprises (WFOEs), Sino-foreign contractual joint ventures (CJVs), and Sino-foreign equity joint ventures (EJVs). In contrast to this, the FIL now serves as the basic law, prescribing the basic principles of foreign investment in China. Foreign enterprises will be subject to the same domestic laws as Chinese companies, being the Company Law of the PRC and where applicable the Partnership Enterprise Law of the PRC. The FIL also unifies the governance of more forms of foreign investment, such as M&A [merger and acquisition] and new project investment, rather than just the establishment of Foreign Invested Enterprises (FIEs).

Secondly, the FIL abolishes the case-by-case review and approval system on market access for foreign investment and standardizes the regulatory regimes for foreign investment by including the negative list management system, a foreign investment information reporting system, and a foreign investment security review system all under one document.

Supplementing this, the FIL also seeks to address common complaints from foreign business and government, such as explicitly banning forced technology transfers, promising better intellectual property rights protection, and ensuring equal treatment for foreign firms in government procurement.

These will all bring great changes to foreign investment regulatory regimes in China, although many matters remain to be implemented by the country’s State Council and commercial departments.

How will the law help China to attract more FDI?

In 2020, China ranked 31st in the World Bank’s ‘‘Ease of Doing Business’’ list and was the only economy from East Asia and the Pacific to join the list of 10 top improvers. China made a jump from rank 78 in 2017 to 31 in 2020 – improving 47 spots in the span of three years. This is a good testimony to China’s commitment to opening up and providing a leveled playing field for foreign investors in the country. Still, there is a long way to go as China still currently ranks behind many East and Southeast Asian nations, such as: Singapore (2), Hong Kong (3), Korea (5), Malaysia (12), Taiwan (15), Thailand (21), and Japan (29). These rankings are of course only indicative, and the parameters considered might not have direct correlation to FDI.

Still, we have seen invigorated efforts by certain ASEAN countries like Thailand, Malaysia, the Philippines, and Vietnam to try and win FDI away from China by providing an alternative to the Middle Kingdom when it comes to capturing shifts and movements in foreign companies’ supply chain and sourcing activities. While these countries could attract an incremental amount of FDI, we have not seen many FIEs completely leaving China given the massive opportunities in the local market.

A combination of the FIL and the “Phase One” U.S.-China trade deal will spur a new wave of interest and ultimately FDIs in China. We have seen a significant amount of cases of particularly U.S. companies that were paralyzed by the trade war in the sense that they did not want to pull the trigger on any China changes and at the same time did not want to invest in alternative jurisdictions until there was some sense of resolution in the dispute. Subsequent phases remain to be seen, but we expect a decent amount of buzz from this trade deal signing corroborated by a more robust framework and legal protection provided by the FIL.

In what sectors is FDI likely to increase?  

This new FIL demonstrates a commitment to providing a more open and transparent business environment and can help China remain competitive among other alternative FDI destinations particularly in the ASEAN region.

FDIs into China have not slowed down, but have shifted toward a marked interest in trading, providing services, and manufacturing operations “in China for China.” The local market still offers huge opportunities to FIEs. We have seen major investments into supporting activities to local retail and distribution channels, in the medical and health care sectors, e-commerce, IT as well as a few financial sectors, which have recently opened up to larger or even total foreign participation.

Additionally, and particularly due to the ban of forced technology transfer and further IP protections, we expect China to attract more FDIs in high-tech industries such as technology, communication, information transmission, fintech, software, and information technology.

In 2017, the CCP wrote itself into Chinese company law. To what extent does the Party now grant itself more power by also subjecting foreign investors to Chinese company law?

The CCP is written in Company Law’s Art. 19: “Where a Chinese Communist Party organization is to be established in the company in accordance with the articles of association of the Chinese Communist Party to develop Party activities, the company shall provide the requisite conditions for such Party organization activities.”

As a general consideration, it is not the first time the CCP writes itself into the Company Law and then, at a later stage, refrains from interventions or edits the norm. It is notable, however, that when it first did so it was in its first version in 1993 and only to indicate that “Activities conducted by […] the Communist Party of China through companies shall be handled in accordance with the Party Constitution.” Therefore, its influence was restricted to the activities carried out by the CCP organizations through companies.

In contrast to this, the 2017 inclusion of the CCP in the updated Company Law allows for party organizations to be created in state-owned enterprises (SOEs) and private enterprises by demanding companies to allow the creation of Party organizations within the corporate structure and to facilitate the relevant Party activities, which presumably will extend the influence of the Party to enterprises regardless of whether they are SOEs or private companies. It is important to remember that there are certain criteria for such Party organizations to be created and that the actual impact that such a change could have in SOEs vs. private entities is quite different.

According to the CCP Constitution, for a Party organization to be formed in a company, there shall be at least three party members (Art. 5), and there is a clear demand in the CCP Constitution (Art. 33) that Party Organizations in SOEs become directly involved in the leadership and key issues of SOEs: “[…] play a leadership role, set the right direction, ensure the implementation of Party policies and principles, discuss and decide on major issues of their enterprise […], guarantee and oversee the implementation of the principles and policies of the Party and the state […], and shall support the board of shareholders, board of directors, board of  supervisors, and manager […]”

The situation is a bit different for private companies, as these only rarely face the request from their Party member employees to arrange Party organizations within the enterprise. The CCP Constitution itself also outlines quite a different goal for such Party organizations (Art. 33). These shall mostly guide and oversee the companies’ other related Party organizations (trade unions, Communist Youth League organizations, etc.) and there is no indication that they would become involved in the leadership or decision-making process of such entities.

Therefore, although such organizations may present challenges to JVs between foreign investors and SOEs, the impact of such a clause will be quite limited in practice for most foreign investors established in the form of Wholly Foreign Owned Enterprises (WFOE). It is important to remember that the amendment of Articles of Association requires unanimous agreement of the board of directors, which means that the foreign investor can effectively block such changes.

Critics have pointed to the FIL’s at times vague wording, especially with regard to forced technology transfers. To what extent do local regulations further specify some of the general language as seen in the FIL?

With respect to forced technology transfer – an issue for which China has been widely criticized – we can refer to the following articles:

Article 24 of the FIL Implementing Regulation provides direct and clear guidance: ‘‘Administrative authorities shall not, directly or indirectly, force foreign investors or FIEs to transfer technologies in any administrative procedures.’’

Article 43 further provides for penalties upon persons in charge for violation of this rule. Together, said clauses aim to eliminate improper governmental interference in technology transfers.

For local FIL regulations, Article 24 of the Shanghai’s FIL Implementing Regulation also provides similar guidance: ‘‘No administrative means shall be used to force foreign investors and enterprises to transfer technology.’’ Shanghai’s regulations also require local government agencies to establish a redressal system to answer and resolve foreign-invested enterprises’ various questions and problems, thus providing an additional layer of assurance against any forced transfer. However, on a practical level, it still remains to be seen to what extent these regulations can be implemented.

What should be added to the FIL to address key concerns of critics?

The FIL just lays down the basic principles for foreign investment. The law and its implementing regulation still lack implementation details on how to protect the legitimate rights and interests of foreign investors. A few examples:

China’s negative list indicates in which industries certain investments are restricted for foreigners. The FIL will regulate “indirect foreign investment,” in part to prevent foreign investment from circumventing negative list management through indirect investment. However, the law does not give any further definition on what constitutes “indirect.” To make things even more complicated, the FIL will apparently not apply to Hong Kong, Macau, and Taiwanese investments, as these will be considered special “domestic” investments. So how would the law function when a more complex and multilayered holding structure is in place?

Additionally, the FIL notes that it will regulate four categories of foreign investment activities: the establishment of FIEs, M&A, new project investment, and investment in other forms. But it does not define “investment in a new project” and leaves this to the reader’s interpretation. For example, does the definition include any investment projects in which a foreign investor does not set up or acquire an enterprise in China, but only relies on contractual relationships (such as natural resource exploration and development concession agreements, infrastructure construction and operation concession agreements, etc.)? And how to apply the foreign investment management system (such as information reporting system, security review system, etc.) for such new investment projects?

Another challenge might be represented by the grace period of five years after the FIL comes into effect. The FIL allows the original organizational form of the established enterprise to be retained for five years. Does this mean that the current contracts and the article of associations of existing FIEs will continue to be effective and be implemented during the transition period, even if the three foreign-funded laws have been abolished? How would disputes over the five-year transition period be interpreted?

Moreover, Variable Investment Entities (VIEs) have been widely used in the past to overcome restrictions in particular sectors. How would these investments be considered going forward? All these questions remain unanswered and will need to be tested in practice. Without doubt, more amendments shall come through in the future months once the government has observed from a practical level the necessity for a recalibration.

This interview has been edited for clarity.