What’s the context?
China’s new foreign investment law, which targets the incorporation and governance of foreign investment enterprises (FIEs), will come into effect on January 1 2020. The law, which was passed at the 2019 National People’s Congress, the annual meeting of China’s legislature, is a move welcomed by foreign businesses.
The framework for foreign investment in China has been governed by the Wholly Foreign-Owned Enterprises law, the Sino-Foreign Equity Joint Ventures law, and the Sino-Foreign Contractual Joint Ventures Law. These three laws do not provide specific protection for trade secrets or forced technology transfer. The new law aims to streamline the existing legislation into a single law that will make China friendlier to foreign investment.
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There are provisions that state specifically that Chinese joint ventures (JV) are prohibited from stealing intellectual property and commercial secrets from their foreign partners (Article 22). In addition, there are strict prohibitions on government officials using administrative measures to pursue forced technology transfers and the disclosure of trade secrets (Articles 22 and 23), and such actions may attract criminal liability (Article 39).
What concerns do existing FIEs have?
Under the existing regime, there are three types of joint ventures, namely, the WFOE (wholly foreign-owned enterprise), the EJV (equity joint venture), and the CJV (cooperative joint venture). The question of fiduciary duty has been unclear with respect to EJVs and CJVs in particular, because although the directors of EJVs and CJVs are subject to fiduciary duty rules, these may be waived under contracts.
One concern is that FIEs will need to reorganise their corporate form to reflect the new law. This won’t be a big issue where a foreign company owns 100% of the FIE and the shareholder of a WFOE will at most need to sign restated articles of association. “Where a foreign investor has a JV with a partner, the partner could make the process difficult and painful by trying to renegotiate the JV terms,” said Paul McKenzie, managing partner, Morrison & Foerster in Beijing.
McKenzie said that if the JV was set up as a CJV, then there may be tricky technical issues conforming the entity’s capital structure to the more restrictive requirements of the PRC Company Law. The details of how all this will be implemented have not been spelled out yet.
“The fiduciary duty of directors of the equity joint ventures matters to many foreign investors in China, and more importantly, to the foreign directors sitting on the boards of foreign-invested companies in China,” said Yang Wang, partner at Dechert.
“With the new law taking effect, it is now clear that directors of EJVs and CJVs owe a fiduciary duty to the joint venture and they are subject to duty of loyalty when sharing information and business opportunities with the shareholders appointing them,” said Wang. A waiver provision in their EJV and CJV contracts, if any, may not be valid nor enforceable anymore.
In the context of fiduciary duty, the EJV and CJV contracts need to be reviewed and revised. Directors may need to be changed due to concerns over personal liability, and discussions may be held regarding directors and officers’ insurance. “However, this may be difficult where the joint venture parties are already in dispute, because one party can use this proposed change as an opportunity to leverage and ask another party for other changes in irrelevant provisions,” said Wang.
According to Betty Louie, partner at Orrick, due to some greater flexibility and potential ambiguity in the new law, new terms may be introduced in the contractual re-negotiation process. For instance, under the existing regime, Chinese natural persons are prohibited as shareholders of a foreign equity JV. Under the new law, the language is silent on this aspect. Currently, foreign shareholders should customarily contribute no less than 25% of the equity JV but the new law is also silent on this issue.
Louie said the existing law stipulates that certain matters require the unanimous approval of all directors present at a board meeting but would only require an approval of two to three of the shareholders with voting rights under the new regime.
What legal uncertainties remain?
According to the European Chamber of Commerce in China, Article 40 of the new law is of particular concern as it allows for political issues to influence investor-state relations. It gives China the power to take unilateral action against trading and investment partners based on a principle of perceived negative reciprocity. Rather than having this legal uncertainty, conflicts should be handled through established multilateral institutions such as the WTO. “More than anything else, foreign companies want equal treatment and opportunities,” said Mats Harborn, president of the EU Chamber of Commerce in China.
What will happen next?
The new law is very broadly-drafted, and implementing regulations are needed. The Ministry of Finance and Commerce (Mofcom) is developing ancillary regulations and policies. While there is technically a five-year transition period, the challenge in implementation will be in the details.
See also: 2019 M&A Report: China