New PRC Rules Establish National Security Review for M&A Transactions Involving Non-Chinese Investors

    By Corporate & Public Finance

    On February 3, 2011, China’s State Council issued the Circular on the Establishment of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (Circular 6), establishing a national security review procedure for the acquisition of a domestic Chinese enterprise or asset in certain sensitive industries or sectors by one or more foreign investors. Circular 6 took effect on March 5, 2011, granting Chinese authorities broad discretion to review certain types of transactions that have not historically been subject to governmental review. Interim rules for the implementation of Circular 6 were issued by China’s Ministry of Commerce (MOFCOM) on March 4, 2011. These rules are only valid until August 31, 2011, and are expected to be replaced at or prior to that date. Circular 6 is the latest in a number of hurdles that must be overcome by foreign investors seeking to invest in the Chinese market and may impact the popular variable interest entity (VIE) structure utilized by Chinese companies seeking to list their equity on foreign exchanges. However, the full effect of Circular 6 has yet to be determined, as no test cases have undergone the national security review as of yet.


    While Circular 6 formalizes the procedures for a national security review, the concept has been part of China’s regulatory framework for foreign investment for some time. China has long restricted or prohibited direct foreign investment in certain industries. Companies in such industries began using the VIE model as a way of circumventing such restrictions. In the typical VIE arrangement, a non-Chinese entity owns all of the equity of a Chinese entity. This Chinese entity is referred to as a wholly foreign-owned entity, or WFOE. The WFOE then enters into a number of contractual agreements with a Chinese operating company. The effect of these contractual agreements is to give the WFOE and in turn, the non-Chinese entity that owns the WFOE, control of the Chinese operating company, without transferring legal ownership.

    In 2006, Chinese authorities issued a series of regulations known as Circular 10. Circular 10 made it necessary to get MOFCOM approval before transforming a Chinese entity into a holding company by setting up an offshore entity, owned by the owners of the Chinese entity, which would then acquire the Chinese entity. While Circular 10 does not completely ban such round-trip investments the process for obtaining MOFCOM approval is so onerous that the practical effect is to prohibit almost all round-trip investment transactions. As a result of Circular 10, companies in other non-restricted or prohibited industries also began utilizing the VIE model. As the Chinese operating entity is not actually being acquired, rather controlled through the VIE agreements, the VIE model should fall outside the scope of Circular 10. Since Circular 10 did not lay out a framework for any type of review process, companies have believed the VIE model to be outside the scope of Circular 10 and simply have not applied to MOFCOM for approval of any such VIE model transactions.

    With the issuance of Circular 6, the Chinese government has now laid out a formalized review process for reviews of foreign investment in Chinese enterprises.


    Circular 6 is generally applicable to two types of transactions: (1) foreign acquisition of any stake in a military enterprise, military supplier, company located near a military facility, or any other company conducting activities related to national defense; and (2) foreign acquisition, rising to a level of control, of a Chinese company operating in an industry deemed to be significantly related to China’s national security, such as agriculture, energy, resources, technology, infrastructure, transportation, and equipment manufacturing. Practically, this means that Circular 6 is applicable to a wide range of transactions that could be deemed to bring significant foreign influence to certain domestic sectors deemed to have national security implications, as well as transactions in other unrelated sectors, if the company is or has facilities located near Chinese military facilities.


    Under Circular 6, any acquisition of the equity or assets of a Chinese company by a foreign investor requires that an application be submitted to MOFCOM. However, only those transactions that fall within the criteria above will proceed to the security review. An acquisition under Circular 6 refers to the following types of transactions: (1) directly purchasing equity shares in a domestic Chinese company; (2) purchasing equity shares of a foreign-invested enterprise (FIE) from a Chinese shareholder or directly from the FIE; (3) purchasing the equity or assets of a domestic Chinese enterprise indirectly through an FIE; and (4) directly purchasing the assets of a domestic Chinese enterprise and operating them by establishing an FIE. The foreign investor is required to submit an application to MOFCOM for any transaction that meets this definition of acquisition, regardless of whether the foreign investor deems the transaction to otherwise meet the other criteria of a Circular 6 transaction.


    For those acquisitions that do not relate to military enterprises, a certain level of control must be attained by the foreign investor in order to trigger a national security review under Circular 6. Under Circular 6, control is attained when (1) one or multiple foreign investors together, own 50% or more of the company’s equity; (2) a foreign investor owns less than 50% of the equity, but has voting rights sufficient to have a material impact on the resolution of any meeting of the shareholders or board of directors; or (3) a foreign investor otherwise obtains de facto control or authority over a domestic Chinese company’s business decisions, financial affairs, personnel or technology. As discussed in greater detail below, the broad definitions of acquisition and control could be read to encompass the VIE model. However, the interim rules for the implementation of Circular 6 have not made it clear as to whether Circular 6 is meant to apply to transactions involving a VIE structure and as such, parties should consult Chinese counsel before proceeding with a VIE transaction.


    Any foreign investor looking to acquire the equity or assets of a domestic Chinese company is required to submit an application to MOFCOM for a review of the proposed transaction. If MOFCOM determines that the transaction falls within the scope of Circular 6, MOFCOM has 5 business days to submit the application to a joint committee, led by the State Council, the National Development and Reform Commission (NRDC) and MOFCOM and comprised of members of other relevant government agencies (the Joint Committee). In addition, if the foreign investor itself does not submit an application, any agency under the State Council, a national trade association, a competitor, customer or supplier of the target company may submit an application requesting MOFCOM to initiate the national security review. As it will often be unclear as to whether a proposed transaction falls under the purview of Circular 6, foreign investors should typically seek the guidance of Chinese legal counsel before proceeding with the transaction.

    Review Phases

    After receiving an application for review, MOFCOM has 5 business days to decide whether a national security review is warranted. If MOFCOM determines that a national security review is warranted, it will request that the Joint Committee begin a review of the transaction (the General Review). During the General Review phase, the Joint Committee has 5 business days to solicit the opinions of other relevant government agencies. Such agencies then have 20 business days to provide the Joint Committee with a response. After receipt of all responses, the Joint Committee then has an additional 5 business days to assess the opinions of the other relevant government agencies. If all opinions indicate that the transaction will not affect China’s national security interests, the Joint Committee will submit an opinion to MOFCOM that no further review is needed and MOFCOM will notify the applicant.

    If any of the opinions from the relevant government agencies hold that the proposed transaction is likely to affect China’s national security interests, then the Joint Committee will begin a special review (the Special Review) within 5 business days of receipt of such an opinion. During the Special Review, the Joint Committee will have 60 business days to conduct an assessment of the security implications of the proposed transaction. If the Joint Committee cannot reach a consensus opinion within 60 business days, the Joint Committee will seek a final determination from the State Council. Thus, the entire process can take as little as 35 business days if only a General Review is needed, or as long as 95 business days if a Special Review is also required.


    If the Joint Committee determines that a proposed transaction poses a threat to China’s national security interests, the Joint Committee will request MOFCOM or any other relevant government agencies to cancel or rescind the transaction or require the investor to modify the transaction so as to eliminate the national security threat. Additionally, it is not clear at this point whether the government will seek to apply Circular 6 retroactively to transactions that were already completed or transactions that were in the process of seeking other regulatory approval. Furthermore, if the parties to a transaction fail to submit an application to MOFCOM, they run the risk that a third party could submit an application to MOFCOM and possibly initiate a security review at an inopportune time in the transaction, or worse yet the Joint Committee could determine to rescind or cancel the transaction after the parties have devoted significant resources to its completion.

    Implications of Circular 6

    At a minimum, Circular 6 will likely act to delay or prolong a number of transactions involving foreign investment, as parties must first evaluate their transactions to determine whether application to MOFCOM is needed, keeping in mind that any acquisition of a Chinese enterprise or asset will require the submission of an application to MOFCOM, regardless of whether the transaction will trigger a review. If a review is required, the parties then must wait for the completion of the review process, which can take as long as 95 business days. Additionally, Circular 6 and its implementing rules have left a number of questions unanswered and it is unclear exactly how much of an impact will be had on transactions involving foreign investors going forward. For instance, it is unclear what types of minority interests will be deemed to have de facto control thus triggering a review. It is also unclear as to exactly what industries will be determined to be significantly related to national security, or how the Joint Committee will weigh different factors when conducting its review.

    Such ambiguities have made it difficult to determine whether the VIE model falls within the scope of Circular 6. It is possible that the broad definitions of acquisition and control could be read to encompass transactions that utilize the VIE model. Furthermore, the fact that a national security review application can be submitted to MOFCOM by any trade association, competitor, customer or supplier of the target company, make it all the more likely that transactions involving a VIE model will be subjected to a security review. In the past, companies were comfortable in the belief that the VIE model fell outside the scope of Circular 10 and that a transaction could proceed without seeking MOFCOM approval. However now that the review process has been formalized and a number of third parties have the ability to report transactions to MOFCOM, parties will likely need to more carefully consider whether to seek MOFCOM approval.

    While it is likely that a number of these questions will be answered when the new implementation rules are issued in the coming months, it is advisable to consult with Chinese counsel to determine whether a proposed transaction requires that an application for a security review be submitted to MOFCOM. The decision as to whether to apply to MOFCOM for review is likely to become a critical decision in all transactions involving foreign investment going forward. The parties to a transaction will understandably be reluctant to involve governmental authorities in a transaction that would not have previously been subject to review unless absolutely necessary. However, as a wide variety of parties not involved in the transaction have the ability to notify MOFCOM of the transaction, the parties to a transaction would be inviting a great deal of risk by not voluntarily applying to MOFCOM at the outset of the transaction, unless absolutely sure that no application is necessary.

    This is particularly true for transactions involving a VIE structure, which is often used by Chinese companies to list their shares on foreign exchanges. If the parties to such a transaction do not notify MOFCOM at the outset of the transaction, they run the risk of devoting a significant amount of time and resources to completing an offering of securities on a foreign exchange, only to see that offering terminated or significantly altered if a third party calls for a security review late in the transaction. If the proper procedures are not followed from the outset, it is possible that a public offering of the shares of a Chinese entity involving a VIE structure on a foreign exchange such as NASDAQ could be completed, only to see the Joint Committee terminate that VIE structure. This would result in the shareholders who purchased shares in the offering owning worthless shares in a foreign shell, which would own the WFOE, but the WFOE would no longer control the Chinese operating company. The entire transaction would have to be reversed in order for such shareholders to be made whole. This would be an extremely difficult process, leaving such shareholders with very limited options. It is therefore critical to seek counsel at the outset of a transaction to determine if the application to MOFCOM for a security review is needed.

    For additional information, please contact the Kaufman & Canoles China Team.

    The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.