Many reasons contribute to the change of foreign investment between industries.  We believe the following two points are particularly influential in recent years.  First, as the increase of Chinese domestic labor costs, land costs, environmental protection and other operating costs, low-end manufacturing industries have lost its edge.  As a result, a large number of them has moved to emerging countries and regions such as Southeast Asia.  Compared to other developing countries, China has good infrastructure, high-quality human resources, mature market and technology and high administrative efficiency.  All these factors provide a solid foundation for the development of high-tech industries, attract foreign high-tech enterprises to invest in China and then empowering them to be based in China and expand globally.  Secondly, encouraged by the trends of cross-border investment by Chinese enterprises, joint venture investments by foreign investors in high-tech fields are becoming increasingly active (see more discussion below).

A.“Round-trip" Model

In recent years, Chinese enterprises have been very active in global mergers and acquisitions.  In a lot of cross-border investment activities, Chinese enterprises do not simply make financial investment overseas, especially considering the various business, policy and legal risks they might incur.  More importantly, many Chinese enterprises intend to bring advanced technologies, management experience, brands, and etc., into the Chinese market and carry them forward in a Chinese way.  Therefore, a number of Chinese enterprises combine outbound direct investment (“ODI") with FDI to make cross-border capital operation.  In this model, a Chinese enterprise first invests in an overseas enterprise and acquires certain equity, and then the overseas enterprise turns to set up a JV with the Chinese enterprise, or a WFOE (in the scenario where the Chinese enterprise becomes controlling shareholder in the overseas enterprise).  Such “round-trip" model, on one hand, enables Chinese enterprises to invest in overseas enterprises for financial returns; and, on the other hand, it facilitates such overseas enterprises to export their technologies, brands, business and management experience, etc. to China via the form of JV, leverage local resources of Chinese investors, such as capital, market, supply, experience in A-share capital market, and etc., and ultimately form a close and stable new JV model.  It is worth noting such “round-trip" model is different from the traditional round-trip model as customarily regulated by the State Administration of Foreign Exchange.

B.Model of ODI Alternate

In the past year or two, some foreign governments have restricted and even prohibited Chinese enterprises from acquiring or investing in certain businesses and assets in their countries, under the name of national security or the like.  For example, the Committee on Foreign Investment in the United States (“CFIUS") recently denied the acquisition of Lattice, an American semiconductor company, by a US private equity fund with Chinese national background.  Furthermore, since the second half of last year, the Chinese government has tightened its supervision on ODI activities in light of the precipitous decline of foreign exchange reserves, which partially was caused by capital flight disguised as ODI.  Consequently, it has become more difficult for Chinese enterprises to cooperate with foreign enterprises in the manner of ODI.  As such, many Chinese enterprises turn to establish JVs with overseas high-tech enterprises within China.  As discussed in Section I above, the establishment of a JV is only subject to registration with the Chinese competent authorities, unless the project falls into the “negative list" and/or involves national security review, merger control review, and/or export control of technology from overseas government.  This business model circumvents the Chinese and foreign regulatory procedures for ODI, thereby reducing the transactional costs and mitigating the regulatory risk in ODI activities.  For instance, a number of Chinese enterprises were prevented by certain foreign governments from investing in integrated circuit industry; in order to overcome such regulatory hurdle for cooperation, these Chinese enterprises chose to establish JVs with the concerned foreign enterprises in China.  That being said, in the event that a foreign enterprise transfers any technologies to a JV, such technology export might still be subject to some regulatory scrutiny of the foreign enterprise’s home country.

C.Model of Chinese-Controlled JV

Due to concerns of information security, network security, financial security etc., the Chinese customers (including particularly governmental customers) are more and more alert to suppliers with pure foreign background in finance, telecommunications, integrated circuits and other industries, even though the foreign investors are allowed to invest in these industries under the existing laws.  Within such context, many foreign investors choose to spin off their business departments and wholly-owned subsidiaries in China and sell majority ownership of such business to Chinese investors, especially those with State-owned background, so as to form Chinese-controlled JVs; and, on the other hand, such foreign investors may still retain certain operational influence over the JVs.  Thus, the Chinese-controlled JVs enable the foreign investors to maintain and even expand into areas that they could not participate through WFOEs, and also help the foreign investors acquire a competitive edge in the relevant market acting as “domestic" manufacturers through the Chinese-controlled JV.

D.Model of A-Share Oriented JV

With nearly thirty years of development, the Chinese A-share capital market has become more mature.  Also, thanks for the long-term steady development of China’s economy, the valuation system of A-share market is generally more optimistic than that of many western stock markets.  FIEs, either through IPO or by participating in material asset restructuring of A-share listed companies, can enter into China’s A-share capital market.  This enables foreign investors to securitize their equity in FIEs.  Moreover, since the financial crisis in 2008, many multi-national corporations have focused their investment in their home countries and begun to spin off their business in China, whether such business is in the form of an independent legal entity or not, and establish JVs with Chinese partners, with the expectation of leveraging resources and experience of Chinese partners to disembark the A-share capital market.

For various reasons, the new FIE models are mostly presented in the form of JVs.  It should be noted that, however, the Law on Sino-Foreign Equity Joint Venture Enterprises (“EJV Law") was enacted and promulgated long before the Company Law, and certain provisions thereof are yet not completely reconciled with the Company Law.  In particular, there is substantial difference between such two laws with respect to JVs (as a special limited liability company) and ordinary limited liability companies.  For instance, the highest authority of a JV is the board of directors, while the highest authority in an ordinary limited liability company is the shareholders’ meeting; in a JV, directors are directly appointed by respective shareholders, while the directors in an ordinary limited liability company are elected at the shareholders’ meeting; and, compared to those of the Company Law, the provisions in the EJV Law are more rigid, e.g., voting mechanism of the board of directors, profit distribution mechanism, liquidity of the equity interest, and etc.  These factors are not conducive for Chinese and foreign investors to reach agreement pursuant to their business intentions and business rationale, making it more difficult to achieve efficiency in investment decisions and actual operations.  We believe that cooperation between the Chinese and foreign investors can be further promoted if the EJV Law is further revised to align with the Company Law.

A.RMB Funds

Since amendment of the Partnership Law in 2006, limited liability partnership has been used more frequently for domestic fund-raising.  More and more fund managers set up domestic fund management companies in China, and raise RMB funds directly from domestic investors.  As resourceful local investors in the FDI area, RMB funds often aim at business units spun off from multi-national companies, new businesses and technologies that multi-national companies plan to bring to the China market, such that foreign investors can take advantage of local resources of RMB funds to localize and improve their businesses and technologies in China.  Compared with traditional industrial investors, RMB funds pay more attention to the financial returns of JVs and RMB fund managers likely have more international exposure and management skills/experience.

B.US Dollar Funds

US Dollar funds were once the most active investors in China’s sector of venture capital and private equity.  Initially, US dollar funds mainly invested in the offshore red-chip Chinese enterprises, and then exited from overseas capital market.  Since US dollar funds are raised primarily overseas and in US dollars (or other freely convertible foreign currencies), their direct investment in Chinese enterprises is deemed FDI and will convert such enterprises into JVs.  Before the reform of the FDI regulatory regime, no matter whether the foreign investment was made in the way of establishing a new FIE, or in the way of acquiring a domestic enterprise and converting the same into an FIE by means of capital increase or share/equity transfer, such investment would require prior approval of competent authorities of China.  On top of that, the approval authorities often took a rather rigid approach when examining the transactional documents for the investment (including usually the joint venture contract, articles of association, share transfer agreement, capital increase agreement, etc.).  Consequently, it often took months, if not years, for a foreign investment project from planning to closing; and, also, the competent authorities may also order the investors to revise the commercially agreed terms and conditions to the satisfaction of the authorities.  With the reform of the FDI regulatory regime, advance approval is no longer required for a foreign investment project that does not fall into the “negative list".  With shortened investment process and less regulatory burden, US dollar funds will naturally become more competitive.  Furthermore, with the A-share market becoming more and more mature and open, US dollar funds will definitely invest in the form of JV more frequently than ever, rather than restructuring a Chinese enterprise into a red-chip structure to make offshore investment.

C.Employee Stock Ownership

Traditionally, employees are not typical investors in the FDI area.  In recent years, with the upgrading of industries and development of A-share capital market, employee stock ownership has become a popular topic.  In a large number of acquisition and corporate financing projects handled by us, especially in the high-tech sectors, employee stock ownership is oftentimes an essential element, and, FIEs are not exception to this.  Please see below more detailed discussion on employee stock ownership.

The diversification of JV partners will inevitably bring about diverse demands for JV projects, which puts up new challenges for the design of investment structure and the terms of legal documents.  In particular, existing laws on foreign investment are still in conflict with the demands of financial investors and employee stock ownership platforms with respect to exit channels, withdrawal methods, minority shareholder rights (such as preferential dividend rights), and corporate governance.  This requires investors and their legal advisers to discuss and seek effective solutions under the existing legal framework.

A.Registered Capital and Source of Funds

Before the Ministry of Commerce promulgated the Notice on Improving the Approval and Administration of Foreign Investment on June 17, 2014, as for newly established JVs, if capital contribution is made in installments, each investor shall pay no less than 15% of its subscription amount within three months as of the date of issuance of the JV’s business license (“Business License Date"), and the remainder amount within two years as of the Business License Date; and, as for JVs established by acquisition, in the case of capital increase, the acquirer should pay no less than 20% of the capital increase amount prior to the Business License Date and the remainder amount within one year as of the Business License Date, and, in the case of share transfer, the acquirer should pay off all the transfer price within one year as of the Business License Date.  After the above notice came out, although the above statutory contribution/payment deadlines are cancelled, investors are nevertheless required to set forth a deadline of capital contribution in the articles of association of the JV.  And, the registered capital must be fully contributed before the JV applies to the China Securities Regulatory Commission (“CSRC") for going public on the A-share market.  In practice, given that many business activities have threshold requirement for registered capital and net assets, and foreign invested enterprises still need to handle issues of foreign exchange control, tax, financial, etc., investors usually tend to apply for a relatively large amount of registered capital.  This may not be a problem for industrial and financial investors who invest in cash, but it is so for employees whose investment is mainly their intelligence and services.  Moreover, ESOP is purposed to essentially work as an incentive to employees.  In fact, many western companies offer incentive shares to employees at nominal or even nil price.  If employees had to pay a fair market price for the incentive shares, it would run afoul of the idea of equity incentive.  Therefore, in designing equity incentive plans for JVs, it is necessary to solve the sourcing problem of incentive shares (i.e., whether to subscribe new shares from the JV or to acquire existing shares from the JV shareholders), as well as the problem of legal source of funds (whether it is raised by employees self-financing, or by shareholders, or through other sources).

B.“200 Persons" Requirement and Shareholding Entrustment

Pursuant to the Chinese securities laws and regulations as well as guidelines of the CSRC, investors of a JV shall ensure that ultimate equity owners of the JV be no more than 200 persons prior to the IPO or share exchange with an A-share listed company, unless otherwise approved by the CSRC.  In fact, with an attempt to circumvent such 200-person requirement and to achieve greater flexibility in management, some companies even had controlling shareholder or key employees directly or indirectly hold shares on behalf of other employees.  Such shareholding entrustment, however, is considered unacceptable for the purpose of listing and must be eliminated before the JV goes public, whether through IPO or back-door listing.  As such, when designing ESOP for a JV, the coverage of ESOP and the number of participants must be carefully determined such that the above issues could be avoided.  Of course, on the other hand, if the CSRC could relax the 200-person requirement when ESOP is concerned, it would boost the development of high-tech enterprises and other enterprises that are highly dependent on the talents.

C.Clear and Stable Ownership Structure

In order to motivate employees, an ESOP usually requires that a participant to work for the employer for a certain period of time, usually 4 or 5 years, or meet certain performance criteria; and, in the event that the participant fails to meet the foregoing requirement(s), the employer retains the right to repurchase the unvested incentive shares or even the vested/exercised shares at a pre-determined price.  Accordingly, the JV's ownership structure may be in an unstable status as a result of such arrangements, no matter when the JV registers the incentive shares for its employees.  Pursuant to the Administrative Measures on Initial Public Offering and Listing of Shares, the Administrative Measures for Initial Public Offering and Listing of Shares on Growth Enterprise Market and other applicable rules, the ownership structure of a to-be-listed company must be clear and stable before it applies to the CSRC.  Similarly, pursuant to the Administrative Measures on Material Asset Restructuring of Listed Companies and guidelines of the CSRC in its practice, the ownership of target assets involved in a material asset restructuring shall be clear and stable, and no change shall occur to the ownership structure of such target assets after the listed company’s announcement of the restructuring plan.  Thus, when designing and implementing an ESOP, a JV shall carefully consider the above requirements, and maintain a clear and stable ownership structure in a legally and commercially feasible manner.

D.Types of ESOP

In practice, an ESOP may be generally carried out in one of the following approaches: (i) the incentivized employees directly hold the equity interest of the JV; and, (ii) employees form one or more holding vehicles, e.g., limited partnership and limited liability company, and indirectly hold the equity interest of the JV through such vehicle(s).  When assessing the above approaches, factors to be considered may include the number of participants, the size of the ESOP pool, source of funds, tax, importance of participants, willingness of participants, etc.  If the ESOP is implemented through a holding vehicle, it is advisable to make appropriate tax planning with respect to the establishment of the holding vehicle.

E.Share-based Payment

Pursuant to No.11 of ­­­­­the Accounting Standard for Business Enterprises — Share-based Compensation, if the employees of a JV acquire incentive shares from the JV or its shareholders at a price lower than the fair market value, then such incentive shares may be characterized as “share-based payment", which is defined as “a transaction in which an enterprise grants equity instruments or incurs liabilities based on the equity instruments for the purpose of obtaining services from employees and/or other parties".  Once an ESOP constitutes share-based payment, it will affect the accounting profit of the JV in the relevant year(s).  A JV may need to pay close attention to this issue if it plans to go public.  Otherwise, if the share-based payment issue is handled inappropriately, the JV may fail to meet the profit thresholds as required by the listing rules, or its listing valuation may be materially damaged.  Moreover, the share-based payment issue must be considered together with the formation of exercise conditions, tax planning, and other related issues such that the JV can come up with a balanced solution for all such issues.

F.State-owned Assets

As for a JV with State-owned investor(s), the question of how to implement a legally enforceable ESOP is challenging.  First, when a JV establishes an ESOP through capital increase, the equity of such State-owned investor(s) may very likely be diluted and therefore state-owned assets valuation and filing procedures, with the competent State-owned assets authorities, will be required; and, a State-owned investor would face huge compliance issues when it intends to transfer its equity in a JV to incentivize employees (especially where the transfer price is below the market price).  Secondly, in the event that a JV is deemed to be a State-controlled enterprise under the Administrative Measures of State-Owned Assets in Enterprises, the capital increase and share transfer shall also comply with relevant State-owned assets procedures, e.g., the requirement of public bidding, auction and listing on a qualified asset exchange.  The above requirements and restrictions should be properly considered when designing an ESOP or even before the JV is established, so as to avoid the embarrassment that ESOP cannot be realized after the JV is established.

G.Foreign Participants

Foreign employees and consultants are oftentimes covered in an ESOP of the JV.  They tend to have higher expectation and demands for ESOP due to their past work experience and environment.  Thus, a good ESOP that involves foreign participants shall not only consider the restrictions on foreign shareholders, foreign employees and foreign consultants under the Chinese law, but also customize the ESOP to address foreign participants’ expectations and demands, which may be quite different from local participants.

H.Tax Treatment

A JV shall also take into consideration the tax impacts of the ESOP on the participants and the JV itself.  Relevant laws and regulations in this aspect include particularly the Announcement of the State Administration of Taxation on the Treatment of Enterprises’ Income Tax regarding the Implementation of Equity Incentive Plans by Chinese Resident Enterprises and Notice on Perfecting Income Tax Policy of Equity Incentive and Technology Investment.  As this is not the main topic of this article, we will not go further on this issue here.