Entering the dragon: venture capital investment in China after WTO

As an integral part of the overall reform of the financial sector being undertaken at all levels of the Chinese government in anticipation of China's formal accession to the World Trade Organization, the Ministry of Foreign Trade and Economic Cooperation (‘MOFTEC'), together with the Ministry of Science and Technology and the State Administration for Industry and Commerce, issued the Provisional Regulations on the Establishment of Foreign Invested Venture Capital Investment Enterprises (the ‘VC Regulations') on August 29, 2001. The VC Regulations came into effect on September 1, 2001.

The venture capital regime in China

Until recently, China had no specific laws or regulations on this type of investment, and foreign venture capital investors have therefore had to rely on China's general corporate law and its foreign investment regime when structuring investments in the PRC. This has presented a number of difficulties for investors.

Foreigners wishing to conduct business in China are required to establish companies in the form of foreign-invested enterprises (‘FIE's) or to acquire an interest in an already established FIE. However, establishing a business of any kind has generally meant a lengthy, uncertain process involving government approvals which are given subject to local and central planning policies and on a discretionary basis. For all investors, this has often proved expensive and time-consuming. For venture capitalists, who may wish to invest in multiple PRC businesses, this has meant having each investment, other than investments in publicly traded shares, separately approved as a foreign investment.

In an investment regime that treats local and foreign-invested businesses separately, target PRC businesses have to be restructured in a manner which permits foreign investment before foreign venture capitalists can acquire an interest. Establishing a new FIE, particularly a joint venture, can be time-consuming, with the negotiations, feasibility studies and approvals that the exercise entails. Restructurings of existing FIEs, involving transfers of equity interests (registered capital) are often complicated and also require various government approvals. The position is further complicated by the fact that the vast majority of businesses in China, including FIEs in the form of equity joint ventures (‘EJV's) and wholly foreign owned enterprises (‘WFOE's), are non-share issuing entities or can only issue shares which are not freely transferable. Even though it became possible as early as 1992 to establish a vehicle that is similar in structure to a common law limited liability company, known as a company limited by shares or joint stock company (‘JSC'), access to this form of entity by foreign investors has been limited.

In addition, the inflexibility of the FIE regime, which presents problems for all foreign investors, is particularly onerous for venture capitalists, whose aim is generally to make shorter-term investments and who need to have a feasible way of exiting the investment and obtaining return for their own investors. The FIE regime, which favours long-term investment and contemplates return on capital rather than capital gains, does not easily allow for a rapid and easy exit.

Other challenges presented by the FIE regime include issues with management under FIEs, particularly EJVs, which are governed solely by a board consisting of investors' nominee directors in numbers corresponding roughly to the equity interests of the investors. Shareholders' meetings are not held, and the only means by which a shareholder can be represented in the management of the EJV is through the board. Cooperative joint ventures (‘CJV's) and WFOEs are in practice generally managed in a very similar manner. There are very few protections for minority investors beyond what can be negotiated in the joint venture contract. This makes the FIE structure generally unsuitable for multiple investors, and has meant in practice that the number of investors must be limited.

Certain major corporate decisions, such as amendment of constituent documents of the joint venture, termination of the joint venture, assignment of registered capital in the joint venture and merger with other businesses by law require the unanimous consent of the board of directors, and in many cases the approval of relevant authorities as well, therefore often stifling the corporate decision-making process. These requirements of unanimity, coupled with the requirement under PRC law that transfers of registered capital, as well as liquidations, of FIEs be subject to a formal system of government approvals, also present difficulties in relation to exiting from investments.

It has been possible since 1995 to establish wholly foreign-owned or joint venture investment companies, or ‘holding companies', with PRC legal person status to hold investments in multiple FIEs. Holding companies allow some degree of administrative control over investee enterprises through a single PRC entity, and, as a result of a gradual liberalization of the rules applicable to foreign-invested holding companies, have become increasingly useful in the consolidation of overhead and group functions, particularly in procurement and sales for a group of subsidiary ventures. Importantly, there is no ceiling on the value of shares or assets which a holding company may require, which compares favourably to the restriction on all Chinese companies other than specially approved holding companies that a company cannot invest more than 50 per cent of the company's net asset value - in other words, all companies other than holding companies are required to be operating entities. However, due to the rigid requirements relating to the contribution of registered capital (at least US$30m), strict requirements on the capital adequacy of the investors in the holding company, a specified minimum number and value of active projects in China and a strict approval process, a limited number of companies have qualified or been prepared to make the significant investment of new capital required to set up a holding company. The investee companies of a foreign-invested investment company retain their FIE status and benefits. However, they also retain the limitations of an FIE - a statutory right of first refusal by other parties on transfers, the need for unanimity on certain basic matters, and the requirement to obtain government approval for transfers, liquidation and so on. As such, holding companies are not ideal investment vehicles for PRC venture capital investment, and the investment company rules have proved most useful for large industrial investors in China.

Venture capital regulations

Although there had previously been directives and decisions published by the central government in relation to the desirability of introducing a legal framework for venture capital investment1, the recent promulgation of the VC Regulations represents the first serious attempt at defining a national legal framework for venture capital investment in China. Essentially, the VC Regulations allow the establishment of a company, in the form of a foreign-invested limited liability company (‘FIEVC'), by foreign investors singly or together with domestic investors with the requisite venture capital experience, for the specific purpose of investing in unlisted high and new technology enterprises. The VC Regulations include provisions dealing with the requirements for foreign as well as domestic investors in the FIEVC, the approvals process, permitted business scope of the FIEVC, exit mechanisms from the FIEVC, and the examination and supervision of FIEVCs.

Prior to the promulgation of the VC Regulations, in October 2000, the Shenzhen Government had issued its own set of regulations for venture capital investment in Shenzhen (the ‘Shenzhen Regulations'), in an attempt to attract venture capital investment, both domestic and foreign, in the Shenzhen Special Economic Zone2. The provisions of the Shenzhen Regulations are slightly more detailed than those of the VC Regulations, but the two sets of regulations essentially cover the same scope.

Analysis of the VC Regulations

In providing for the establishment of FIEVCs, the VC Regulations allow the creation of a new special-purpose investment company for foreign investors which can hold interests in multiple enterprises simultaneously, using currently permitted FIE structures. This is similar to the role played by holding companies, although it is clear from the VC Regulations that a FIEVC is not a foreign-invested holding company or subject to the holding company rules.

Under Article 2 of the VC Regulations, the FIEVC can take the form of (i) an EJV with limited liability, (ii) a CJV with legal person status and limited liability, (iii) a CJV without legal person status and with liabilities of the CJV contractually allocated as between its investors (i.e. similar to a general or limited partnership), or (iv) a WFOE with limited liability, where there is no Chinese partner. ( By way of contrast, a foreign-invested venture capital company that may be created under the Shenzhen Regulations can only take the form of an EJV or a WFOE. Domestic venture capital companies, however, can take the form of a JSC, an option not permitted under the Shenzhen Regulations or VC Regulations to foreign investors.)

The VC Regulations are expressed to be formulated in accordance with the PRC Company Law (which also applies to FIEs) and the various regulations governing FIEs. In concept, therefore, in the absence of any provisions to the contrary in the VC Regulations, a FIEVC is an FIE and regulated as such.
The establishment of an FIEVC requires the approval of MOFTEC itself (upon submission by a provincial authority), after consultation with the Ministry of Science and Technology. A decision should be made within 45 days after the application is submitted.

The VC Regulations follow the rules relating to holding companies (as well as those applicable to foreign-funded financial institutions) by imposing financial and other criteria on investors. At least one of the foreign investors in the FIEVC must be principally engaged in venture capital investment, have not less than US$100m under management, have invested in not less than US$50m in the three years preceding its application to set up the FIEVC, have experienced personnel, and must make a capital contribution to the FIEVC of not less than 3 per cent of the total capital contribution made by all investors. In addition, at least one of the foreign investors must have net assets of at least US$100m and contribute at least US$20m. Each foreign investor must have the ‘capability to bear risks' and invest not less than US$ 10m, or US$20m, where the foreign investor is the only investor in the FIEVC. Consistent with the general regulations on FIEs, the capital contribution to a FIEVC made by all foreign investors must not be less than 25 per cent of the total capital contributions.

Where the FIEVC includes Chinese investors and takes the form of an EJV or a CJV, at least one of the Chinese investors must also be principally engaged in venture capital investment, have invested in not less than RMB30m in the preceding year, have experienced personnel, and have invested at least US$5m in capital contribution to the FIEVC.

The requirements relating to the investors raise a number of questions. Certainly, requiring proof of experience on the part of a fund manager as evidenced, in part, by the amount of funds under management may be a reasonable precaution. It is, however, by no means clear why there should be one investor with US$100m in assets and a US$20m commitment. It would be reasonable to require the investors to produce evidence of firm commitments for the venture capital funds raised before approving the establishment of the FIEVC. However, in a case where the FIEVC is a legal person and the investors are not individually liable for the debts of the FIEVC, it is not at all clear why one investor should be required to be so substantial or why it should individually make such a large contribution.

Articles 7 and 8 of the VC Regulations deal with registered capital. The result of the requirements described above is that the minimum registered capital for a WFOE is US$20m and for a joint venture is US$25m. In accordance with rules applicable to all FIEs, 15 per cent of this amount must be paid in within 3 months after the issue of the business licence of the FIEVC; the remainder must be paid in within 3 years after the issue after the business licence. This allows some flexibility in drawing down commitments for particular investments. However, it also means that all commitments must be drawn down within this 3 year period whether or not attractive investments are available. The only method currently available to avoid this would be to apply to reduce capital - a time-consuming process and not likely to be successful if the effect would be to reduce capital below the required minimum amount.

The permitted business scope of FIEVCs is laid out in Article 12 of the VC Regulations. This is: (i) investment of their own capital in high and new technology industries where foreign investment is encouraged or permitted, (ii) provision of venture capital related consulting services, (iii) provision of management consulting services to investee enterprises, and (iv) other businesses approved by MOFTEC. (The Shenzhen Regulations also expressly allow direct investment in or participating in the establishment of an enterprise incubator, which is not mentioned in the VC Regulations.) FIEVCs are not allowed to engage in:

(i) investment in industries in which foreign investment is prohibited

(ii) investing in publicly traded securities or financial derivative instruments, excluding shares held by the FIEVC after the listing of its investee enterprises, or as a result of share dividend or share placement by the investee

(iii) investing in real property that is not for their own use

(iv) investing with borrowed money

(v) investing with funds not owned by the FIEVC itself, and

(vi) providing loans or guarantees. In short, apart from management assistance and direct equity investment, the FIEVC cannot provide financial aid or support to investee companies even if willing and financially able to do so, and permitted to do so by its investors. It can also not invest in Chinese equity markets, although offshore venture capital funds could and on occasion do take up a strategic interest in a listed company.

The VC Regulations also provide for the management of FIEVCs. Essentially, FIEVCs are to be managed in the same manner as ordinary FIEs, i.e. through a board of directors (in the case of an EJV, CJV with legal person status or a WFOE) or a joint management committee (in the case of a CJV without legal person status). Article 14 provides that the board or the joint management committee shall make decisions on all material matters relating to the FIEVC. Thus, the issues mentioned earlier in relation to representation of minority investors, the unanimity requirement for certain discussions (both those required by law and those agreed in the joint venture contract) continue to be relevant, both in the management of the investee companies and that of the FIEVC.

Generally, the mode of distribution of profits from FIVCEs is also similar to the distributions from ordinary FIEs. In a Chinese company, profits are not distributable unless the FIEVC has made a profit after tax and payment of losses brought forward. Article 15 provides that in the case of a CJV without legal personality, the investors may stipulate profit distribution ‘according to international practice'. Presumably this is intended to allow for approximation of a limited partnership structure and profit share and permit an appropriate after-tax distribution to be paid to the entity which effectively acts as general partner. The advantage of a CJV, even in a limited liability form, has always been that it allow for flexibility in the allocation of liabilities and profits. The implications of allowing for profit distribution ‘according to international practice' is therefore not at all clear.

In the case of an EJV, where profits must be distributed pro rata to equity contribution, the same flexibility is traditionally not possible, and the VC Regulations do not make any change to the general position. Article 15 allows for the Articles of Association of an FIEVC with limited liability to stipulate ‘compensation for the outstanding performance of the managers in accordance with the law'. There is, however, no need specifically to permit the inclusion of this stipulation in the Articles - under existing FIE law, such a provision could in any event be included, or, more commonly, the board would make its own determination on the appropriate compensation for managers.

The content of this article suggests that the aim is to deal with the remuneration of a foreign manager which is effectively acting as the manager of the FIEVC on behalf of all investors, the reference to performance of the managers does not attempt to deal with this aspect. In fact, the position of an investor which is also acting as a fund manager in China is complex, due to limitations on foreign enterprises directly managing FIEs, combined with the possible Chinese tax implications of a foreign enterprise carrying on business in China by managing a FIEVC. Article 21 does, however, suggest that the drafters did see the role of one of the foreign investors as providing fund management services, as it provides that the foreign investor with VC management experience and funds under management (somewhat ominously described as the ‘Principally Liable Investor') may not withdraw its capital contribution during the term of the FIEVC (which cannot exceed 12 years) except under ‘special circumstances').

The VC Regulations also try to deal with the issue of exit. FIEVCs are allowed to employ any exit mechanisms that are permitted by PRC laws and regulations. Examples of permitted exit mechanisms are set out in Article 20 of the VC Regulations; these are expressed not to be exhaustive and include: (i) equity transfer to other enterprises or individuals, (ii) subject to the agreement of the investee enterprise, equity buy-back by the investee pursuant to an equity redemption agreement between the investee and the FIEVC, and (iii) share sale on a stock market within or outside China, provided the relevant investee enterprise has satisfied the requirements for listing and has secured a listing successfully.

There is currently no real mechanism for equity interest buy-backs other than through a reduction of capital. Article 20 provides that such a buy-back may be effected through detailed rules, which are, however, yet to be issued. In addition, in connection with exit by sale of equity interest, Article 25 of the VC Regulations provides that equity interests in investee enterprises shall be non-transferable by the FIEVC until the capital subscribed by it has been contributed in full - a restriction that potentially locks up all investments until 3 years after the date of issue of the business licence. For the moment, therefore, the FIEVC structure does not answer any of the issues relating to exit which currently exist.

The original investment approval, although given at a local level, must be filed with MOFTEC within one month. Failing such filing, the approval is void. Under Article 26, the transfer of equity interests in or termination of an investee enterprise must comply with the relevant procedures laid down by the State Administration for Industry and Commerce, and shall also require the approval of MOFTEC, which must in turn obtain the consent of the Ministry of Science and Technology before issuing any such approvals. The consequence of these two provisions is that investment and divestment by a FIEVC potentially requires more government approvals than investment or divestment by an offshore company - particularly if it invests through a single purpose offshore investment company, which can be sold without any Chinese government approvals at all.

A fundamental issue which is not adequately dealt with in the VC Regulations is related to capital. Although a FIEVC could recover its capital and a return on capital by selling its equity interest in an investee company, a FIEVC structured as an EJV could not return the capital to its investors as a distribution of capital unless it reduced its own capital. A CJV has somewhat more flexibility to reduce its capital over the term of its operation, although the investors to whom capital is returned remain liable for the capital. A WFOE suffers from much the same issues as an EJV. As noted above, the minimum capital requirement may also be an issue if a reduction is sought. Unless this issue is clarified in subsequent implementing rules, it appears that most FIEVCs will have to reinvest all capital returned to them during the term of operation and/or retain the capital until the FIEVC is liquidated. Early liquidation may also be a possibility if the FIEVC successfully realizes all of its investments prior to the end of the joint venture term and it is specifically referred to in Article 22.

An interesting aspect of the VC Regulations is the specific reference to CJVs without legal personality (a form of investment which has not been encouraged by MOFTEC) and the provisions of Article 16, which establishes the general principle of joint and several liability for investors, but also allows the investors to stipulate that one or more of the investors bears joint and several liability for all debts of the FIEVC, which the liability of the other investors is limited to specified debts of the FIEVC. While it is doubtful that foreign investors will take much comfort from this provisions in the absence of a comprehensive limited partnership law, it certainly shows that the Chinese authorities are looking closely at international practice.

A note on taxation

Article 23 of the VC Regulations provides that investee enterprises of FIEVCs are considered to be FIEs. This circumvents the technicality in PRC tax law that enterprises formed by two enterprises with PRC legal person status (even though they may be FIEs) are not accorded with FIE status, as there is no ‘foreign' party (i.e. a party without legal person status) in the formation of the new enterprise. The provision in Article 23 mirrors the exception from this general rule granted to investee enterprises of holding companies, and effectively allow the investee enterprises to take advantage of the tax benefits that enterprises with FIE status enjoy.

As seasoned PRC investors would know, FIEs receive highly preferential tax treatment compared to their domestic counterparts, including the ability to defer payment of income tax and exemption from stamp duty payments. With China undergoing tax reform as part of its WTO commitment of national treatment of foreign and domestic enterprises, however, the elimination of some of these incentives is to be expected.

Specific tax issues also arise from the expectation that returns will be in the form of capital gains. If a venture capital fund invests in a FIE from outside China and subsequently sells its investment, it will be subject to a withholding tax on profits in China (technically 20 per cent, although in practice now generally levied at 10 per cent). If the venture capital fund invested through a single purpose offshore entity, it may be liable to no income tax at all on the sale. Without a specific ruling, however, the FIEVC will be subject to Chinese income tax on any capital gain (at a top rate, if applied, of 30 per cent national and 3 per cent local tax). Before FIEVCs can be truly feasible some clarification of tax issues will be necessary.

Conclusion

The passage of the VC Regulations represents a welcome attempt by the Chinese authorities to encourage venture capital investment. However, they do not address the major problems for venture capitalists which arise from limitations inherent in the existing FIE investment regime. This is largely due to the fact that the VC Regulations simply mandate the establishment of a foreign-invested venture capital company under the FIE structure, without attempting to break new ground or relax current restrictions under the FIE regime in relation to issues such as the streamlining of the approvals process for multiple investments, transferability of equity interests in investee enterprises, and the management of the FIEVC. The limitation to high and new technology investments, which does not acknowledge the contribution of VC to all sectors of the economy is also disappointing. In drafting the VC Regulations, MOFTEC did show willingness to receive and review suggestions from outside sources. This is encouraging, since a VC structure, to be successful, must be able to accommodate the often complex tax and legal considerations applicable to the various investors. We hope that these issues will be more comprehensively addressed in the implementation rules which are expected to be issued in respect of FIEVCs.

First published in the Asian Financial Law Briefing - November 2001

For further information about this article or related matters, please contact Vivienne Bath ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it ) at Coudert Brothers, Sydney on +61 2 9930 7500 or Cecily Pang ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it ) at Coudert Brothers, Hong Kong on (852) 2218 9100

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