Solving PRC Legal Issues to Minimize Risks For Private Equity Investors

Luke Filei, senior lawyer at CMS Cameron McKenna's Beijing office spoke before venture capitalists about "Solving PRC Legal Issues to Minimize Risks For Private Equity Investors" on 18 June 2002 in Hong Kong.

Luke outlined some of the legal issues affecting overseas private equity investors and other investors alike in their investments in China and suggested some practical solutions for those issues.

1. Structuring PRC Corporate Vehicles

1.1 General

• rigid requirements on business scope;

• time limit for capital contribution;

• JV partners armed with veto rights on amendment of constitutional documents and transfer of interests;

• the absence in PRC law of detailed regulation vesting corporate governance authority within foreign-invested enterprises (FIEs); and

• the absence of detailed regulation arming investors with rights to receive detailed operational information. 1.2 Rigid Business Scope With limited exceptions, all companies in China must have a definite scope of business, within which they must operate. In order for a FIE in China to carry out business other than that authorized in its business licence (e.g. a software production FIE seeking to expand into telecommunications business), it may be necessary to restructure the existing FIE or to establish additional entities. Each of these procedures is subject to onerous governmental approval requirements. One exception to this is enterprises registered in Beijing Zhongguancun Scientific and Technological Park have been allowed, since early 2001, to be established with "no business scope" which can freely conduct business of any nature, save for those prohibited by law or requiring separate prior approvals from governmental authorities. 1.3 Veto Rights Under the current PRC legal regime, where one party to a Sino-foreign joint venture ("SFJV") disposes of its interest in the enterprise, the other party or parties will be entitled, as a matter of law, to a veto right over such disposition. Similarly, any party may veto material constitutional changes such as amendments to the SFJV's articles of association. It is vital that such veto rights are carefully framed in the joint venture's constitutional documents and workable deadlock provisions are provided for in the relevant documentation. 1.4 Corporate Governance To avoid the pitfalls that may arise due to the lack of detailed regulation concerning corporate governance of FIEs, the constitutional documents should establish a clear breakdown of the respective authority of legal representative, board of directors (or management committee, as the case may be), general manager, and deputy general manager and, importantly, the foreign party should retain the right to appoint the legal representative and other major management. In PRC law, the powers of a FIE are vested in its directors and management and, in the absence of contractual provision, shareholders have no rights in relation to operational matters. 1.5 Operational Information Foreign investors often find that they are not kept adequately informed of the operation of investee FIEs. PRC law does not provide detailed rules on the rights of investors to receive operational information. As such, documentation is necessary in order to provide explicitly for such mattes as (i) a budget approval process, (ii) the right to receive accounting information, (iii) regular detailed reports regarding receipts, orders and production, and (iv) an independent audit right to be enjoyed by the investors. 2. Entry Terms 2.1 Government Approval Indispensable Foreign investors should be aware that all foreign investments in China are subject to the prior approval of Chinese government. Constitutional documents and any amendment thereof are required to be submitted to the government for examination and approval. Investors should consult their legal advisor as early as practicable so as to expedite the application process. 2.2 Parties' Capital Contribution The timing and method of capital contributions by investors are highly regulated. 2.2.1 Timing The payment of capital contributions to an FIE in China must strictly conform with certain time schedules prescribed by the law. For example, if the contributions are to be made in phases, at least 15 percent of the registered capital must be paid in within 90 days after the issuance of a business licence. 2.2.2 Method An example on the restriction of how capital may be contributed is that, as a general rule, in an FIE, capital injection by using intangible assets is limited to 20 per cent of the total registered capital. In some exceptional cases, the ceiling of 20 percent may be lifted to extend up to 35 per cent, but this only applies in the circumstance where the intangible property is high and new technology certified by the relevant authority. 2.3 Capital Structure Currently, most FIEs in China are non-share issuing companies. While Sino-foreign joint stock companies may issue shares, the Chinese law is silent on whether such companies are allowed to issue different classes of shares. Thus, the current Chinese law is generally seen as unsuitable for complicated corporate structures (e.g. creation of preference shares) that are commonly used in offshore investments. 2.4 Technology Transfer Where the investment by foreign investor(s) involves a technology transfer or license to its investee in China, caution should be taken to ensure that the statutory requirements on the registration or the approval (as the case may be) of the relevant contracts have been fulfilled. Failing that, royalties payable under the relevant contracts cannot be remitted out of China. Foreign investor should impose a contractual obligation on the Chinese counterpart to carry out such procedures. 3. Exit Terms 3.1 General China has not yet built up a sound "exit" mechanism for venture capital investment, which makes it difficult for foreign venture capital investors to cash their investment 3.2 Trade Sale 3.2.1 The sale of interests in an onshore PRC company not only requires the prior consent of an investor's joint venture partner but also needs governmental approval. 3.2.2 "Tag along" and "drag along" clauses of the type which are common in offshore investments have yet to be accepted in China. 3.2.3 RMB currency received on capital account is not freely convertible, foreign investors may sometimes find it difficult to remit foreign exchange out of China. This is so especially in the circumstance where the foreign investor's ownership in an onshore PRC company is less than 25%. 3.2.4 Tax Considerations Capital gains realised on the sale of an equity interest in an FIE by a foreign investor are generally subject to a withholding tax at a rate of 10 per cent, unless a lower tax rate is provided for in, or exempted by, an applicable treaty in which China is a signatory. 3.3 Going Public Though the Chinese government encourages Chinese companies to go public and seek overseas listing, listing on the foreign stock markets requires an approval or a "no comment" reply from China's Securities Regulatory Commission. Where the Chinese company is engaged in telecommunication related business, an approval from the Ministry of Information Industry is also required. These lengthy procedures slow down the process for Chinese companies going public. On the other hand, China has recently permitted FIEs in China to be listed on the domestic stock exchanges. However, an FIE wishing to list on the domestic exchange may expect to face a log jam as there is likely to be a severe backlog of FIEs wishing to seek a listing domestically. 4. Offshore Investments A number of the above issues can be avoided by structuring investments through offshore vehicles. Venture capitalists will enjoy more flexibility in devising capital investment structure (e.g. creation of preference shares is feasible) and regulating relationship between shareholders and directors and other management. An offshore structure may also provide more tax efficient (most offshore investments are routed through low tax centres) and less onerous exit routes, as no government approval is necessary. For these reasons, the offshore/onshore structure remains the most popular investment route. Disposals to domestic PRC buyers may, however, necessitate sale of an onshore entity. 5. Onshore Investments in the Future In order to bring the Chinese law on venture capital in line with international practice, the Chinese government issued the Tentative Provisions concerning the Establishment of Foreign-funded Venture Investment Enterprises in September 2001. These recent regulations seeking to introduce a category of domestic venture capital enterprise suffer from limitations which need to be ironed out before this type of enterprise can develop. However, this reform process may give rise to a workable onshore investment structure. The above is by no means intended to be exhaustive in relation to the risks of investing in China and any solution thereof. If you need more information on this, please contact Luke Filei at 86 10 6590 0389 or luke.filei@cms-cmck.com. CMS Cameron McKenna