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A Win for Foreign Businesses in China’s New Foreign Investment Law

Summary

In the halcyon days before the pandemic, when headlines were dominated by the mundane trials and tribulations of the US-China trade war, China enacted a sweeping new Foreign Investment Law as the worst of the hostilities began to die down. The regulations enshrined in this high-level law provide many of the concessions that the US and other G7 nations with investments in China had long been clamoring for, but also contain provisions to review foreign investments for national security concerns.

It has been over four decades since Mainland China first began opening its markets to foreign companies. For the majority of this period, foreign investment in China had been controlled by three laws: the Sino-foreign Equity Joint Venture Law (first adopted in 1979), the Sino-foreign Cooperative Joint Venture Law (first adopted in 1988) and the Law on Wholly Foreign-Owned Enterprises (first adopted in 1986). While these laws have gone through numerous revisions, they had in many ways long outlived their shelf lives. The all-encompassing Foreign Investment Law, which came into effect at the beginning of 2020, has served as a long-needed update, repealing the older three law regimes and laying out a path for more nuanced regulation of foreign investment in China.

Looking at the history of the enactment of this new law, it appears that its passage was in no small part motivated by pressure from the US and other G7 nations. The initial version of the law was introduced in 2015, only to be shelved for years before being reintroduced in early 2019 and fast-tracked for promulgation a few short months later. With its passage, many aspects of foreign investment regulation in China will now fall under domestic law, essentially providing national treatment to many foreign companies operating in China.

What’s New in the Foreign Investment Law?

As legal codes go, the Foreign Investment Law (FIL) is not particularly long nor overly technical, and it serves as a foundation upon which other legislation can be added to clarify ambiguities or address novel situations. The Implementing Measures of the Foreign Investment Law (promulgated at the same time as the FIL) serves to clear up certain ambiguities, but there are other provisions in the law that carry implications that only time will clarify.

Nonetheless, as it is written, the FIL has provided a number of welcomed changes to China’s investment environment. It offers more permissive corporate governance: foreign invested enterprises will now be subject to the same corporate governance rules as domestic companies, which is generally subject to China’s Company Law or Partnership Law. In short, this means considerably more flexibility in how foreign investments in China can set up their control structures. Next, foreign firms will have greater flexibility in funding. The FIL expands options for funding investments in China compared to the prior controlling law, allowing capitalization using equity rights as opposed to only cash or property rights. Additionally, recent foreign investment reforms will be codified by being included in the law. This is a welcome change to all foreign companies operating in China, as a key component to this is the Negative Lists that entered into use in 2016. Lastly, the law will see increased intellectual property protections for foreign businesses, which fall in line with recent changes to China’s Trademark Law and Patent Law. The FIL also contains provisions emphasizing the obligation of government entities for the protection of the intellectual property of foreign investments. In particular, these last two changes represent important concessions China has made in order to further liberalize its markets.

Concessions to US Pressure?

In the aggregate, the FIL provides a welcome update to China’s foreign investment scene, particularly for Western businesses and governments that have clamored for more market access and stronger protections. More permissive corporate governance rules will allow the potential for more direct control of foreign investments over their China-based businesses. Greater flexibility in the funding of foreign invested enterprises will facilitate capital inflows into China. More exciting still are the provisions that purport to level out the playing field between foreign companies operating in China and domestic concerns.

The Negative List, Explained

Arguably, the most important of these changes is the codification of Negative Lists. The Negative Lists are two lists jointly released by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM). One list is aimed at the regulation of foreign investment in free trade zones while the other applies to foreign investment in China generally. The Negative Lists function by laying out prohibitions for foreign invested enterprises from operating in specifically defined areas of the economy. By delineating the areas foreign invested enterprises are not allowed to invest in (or, more often, where investment is limited to the foreign investor holding no more than a specified percentage of the investment) as opposed to what is allowed, foreign companies operating in China should have a clearer view of what is permissible, and the ease of doing business should be improved.

The Negative List regime predates the FIL, first coming out in 2016. However, the FIL formally codified the negative list in Article 4, providing assurance that the framework will be in place for many years to come. The significance of this can only be appreciated in full by comparing it to what came before – the MOFCOM Catalogue. While the MOFCOM Catalogue had been liberalizing year-by-year, the Negative List framework removed the universal review and approval processes from the equation. Now, under the Negative List framework, foreign investors are offered the same market access as domestic entities unless restricted for national security or public welfare reasons.

Provided a sector is not subject to the Negative Lists, Article 4 also clearly indicates that the “State affords national treatment to foreign investment outside the negative list.” This promise of national treatment for foreign enterprises is also echoed in Article 16 of the law, which promises equal treatment of foreign investment in government procurement. Articles 25 and 26 also provide strengthened protections, emphasizing the requirement of local governments to honor and enforce foreign investor contracts and providing a complaint and resolution mechanism through which administrative actions can be challenged.

The Fight for IP Rights

The FIL also provides language strengthening IP protections in China. Concerns about China’s problematic enforcement of IP rights have been at the center of the China-US trade war, and the FIL reflects an important concession on the issue by China. While not addressing the specifics of IP rights, Article 22 of the FIL does include language reading “The State protects the intellectual property rights of foreign investors and foreign-invested enterprises; protects the lawful rights and interests of intellectual property rights holders and relevant rights holders; and for acts infringing on intellectual property rights, will strictly pursue legal responsibility in accordance with law.”

More importantly, however, is a subsequent clause prohibiting a practice that has long frustrated Washington and many other developed nations – “The conditions for technological cooperation are to be determined through consultation by the various parties to the investment on the basis of equality and the principle of fairness. Administrative organs and their employees must not force the transfer of technology through administrative measures.” While some commentators have worried about ambiguities that could blunt this clause (i.e. what exactly is an ‘administrative organ’), if the spirit of the clause is observed, then it will go a long way in eradicating a practice that has poisoned China’s relationship with foreign investors over the past several years. In conjunction with recent or soon-to-take effect amendments to China’s Trademark Law and Patent Law providing enhanced protections of IP rights, China is on a full court press to convince the world that it means business when it comes to the stronger protection of IP rights.

Every Rose Has Its Thorn

While China has spun the FIL as a simplification and liberalization of its foreign investment regime, not everything in the new law is rose colored. There will, of course, be hiccups as foreign companies and partnerships operating in China come to terms with the new law. The FIL gives companies a five-year grace period to transition into the new system. In general, this means redrafting and reissuing corporate governance documents. While this can represent a considerable investment of time and effort, the burden is at least partially mitigated by the fact that new corporate governance documents can be drafted in more flexible ways than before. It may take companies some time to learn to navigate the intricacies of China’s domestic company and partnership laws after operating under their own special set of more restrictive laws for the past several decades, but ultimately this transition should be to the benefit of foreign companies operating in China.

The real threat posed by the FIL comes in two provisions through which many of the protections afforded by the law could conceivably be tossed out at the whim of the State Council. Article 35 provides that China will “establish a security review system for foreign investment and conduct security review of foreign investment that affects or may affect national security.” China has not been shy about using national security to stifle investments in the past, most notably in recent years was China’s indifference to the heavy-handed overtures of Mark Zuckerberg to gain Facebook a foothold in China back in 2016. Perhaps China opening up its market to a social media giant may have been overly optimistic, yet the national security loophole presents a potential danger of heightened regulation or outright prohibition of foreign investors operating in a wide range of industries.

Over the past decade, the Committee on Foreign Investment in the United States (CFIUS) has focused more and more of its efforts on scrutinizing Chinese investment in the United States. The trend reached a fevered pitch during the Trump Administration and shows no signs of slowing under the Biden Administration. In years past, China has couched its protection of domestic industries under the guise of its status as a developing nation, but as more and more regions of China reach levels of development congruent to that of the West, this excuse has become untenable. Instead, arguments centering around national security have come to the fore, mirroring the arguments CFIUS plays up in the United States, though perhaps without the sophistication. Article 35 could plausibly carve out a role similar to the function CFIUS holds in the United States, providing a more sophisticated legal framework through which to regulate or discriminate against foreign investment in sensitive sectors than simple ad hoc decrees handed down from the State Council as is the current norm.

Article 40 also represents a potential source of uncertainty for foreign companies doing business in China, particularly for American enterprises. The Article provides a mechanism whereby China may take retaliatory measures where “any country or region takes discriminatory prohibitive, restrictive, or other similar measures against the People’s Republic of China with respect to investment.” This seems clearly aimed at the United States and any ally persuaded to follow US leadership in sanctioning the operations of Chinese companies within their borders. To what extent China will use the provision remains to be seen (the pandemic has put a damper on international foreign investment across the entire globe), though this could prove to be a powerful weapon with which to retaliate against Western pressure, as it can provide justification for targeted reprisals of foreign companies operating in China’s massive market.

Whereas China once lacked the retaliatory toolbox that the US had during the trade war due to its trade surplus, in terms of foreign investment, China may now have the strategic advantage as, despite concerted efforts by Chinese companies to establish a larger presence overseas, there is far more accumulated US foreign investment in China than there is Chinese foreign investment in the US. While many Western companies already operating are in the hi-tech sector and unlikely to be spurned by the Chinese government in view of the potential access to cutting edge technology they provide, there are plenty of foreign companies which have a huge China presence but offer little if anything in the way of technical innovation – think McDonalds and KFC for the US or Carrefour for France, for example.

FIL: Too Good To Be True? Time Will Tell…

Overall, the FIL heralds a significant liberalization of China’s markets. Significantly, it codifies trends that have been coming together for several years, many of which are responsive to the complaints of foreign nations. The law simplifies the legal regime that controls foreign investment in China, and takes a big step towards leveling the playing field between foreign investments and domestic entities. While it may not be at the level of liberalization seen in many developed nations, China’s slow march towards market liberalization is clear, as represented by its marked improvement in its World Bank’s ease of doing business rankings over recent years (as of 2020, China ranked 31st by the World Bank, only a few spots behind Japan, though still considerably behind more liberal East Asian markets such as Hong Kong or South Korea).

COVID-19 has severely hampered international investment over the past year, and China may well have used this to its advantage, offering the appearance of liberalization when many foreign companies were not in the position to take advantage of the opportunity. As the world begins to slowly shake the pandemic’s stifling grip, only time will tell if China’s actions will live up to its promises.

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