China unveils a national security review mechanism for foreign acquisitions of onshore enterprises

Name:  Circular of the General Office of the State Council on Establishing a Security Review System for Mergers and Acquisitions of Onshore Enterprises by Foreign Investors (国务院办公厅关于建立外国投资者并购境内企业安全审查制度的通知, the “Circular”)
Issuing authority: The General Office of the State Council
Effective date: 5March 2011
Subject: National security review of foreign investment

With the news that the Canadian government is to review the proposed acquisition by PetroChina of interests in a shale gas project from Canada's Encana Corporation on “national security” grounds, the General Office of the State Council has announced the introduction of a formal national security review regime by publicly announcing the Circular which it adopted on 3 February 2011. Whilst this could potentially be seen as a tit for tat reaction against foreign governments scrutinising Chinese investments on the grounds of preservation of national security, in fact this regime can be traced back to the 2006 Provisions Concerning the Acquisition of Domestic Enterprises by Foreign Investors (“M&A Provisions”) which required foreign investors to apply to the Ministry of Commerce (the “MOC”) for a national economic security review of any proposed acquisition of a PRC domestic enterprise. Whilst previously no formal review application was required, we understand that in practice over the past few years the PRC government authorities have been monitoring foreign investment in the PRC with an eye to national security. It is therefore unlikely that the Circular is intended to raise the bar against foreign investment into China.

However, the issue of the Circular is a clear signal that the PRC government does propose to take a more systemic approach in monitoring foreign investments in sensitive sectors. And perhaps the more concerning aspect of the new rules is that the relevant authorities appear to have been mandated to review existing investments with the power to require the disposal of any investment if they determine that it has, or is likely to have, a material impact on national security. It remains to be seen how strictly the government will enforce this.

The Circular sets out a detailed mechanism for a review on national security grounds and, to some extent, provides a degree of clarity and certainty to foreign investors in cross-border acquisitions. However, as with many regulations in the PRC, interpretation of a number of provisions will be subject to the discretion of the relevant PRC authorities, with consequential uncertainty about the exact scope of application of the rules.


Transactions subject to review

An acquisition by a foreign investor of a PRC enterprise will be subject to review on the grounds of national security in the following circumstances: (i) an acquisition by a foreign investor of any stake in a PRC military or military supportive enterprise, any enterprise locatedin the surrounding area of important or sensitive military facilities and any other enterprise which is of importance to national defence security; or (ii) an acquisition of a controlling interest in a PRC enterprise within a sensitive sector, such as key agriculture, key energy and resources, key infrastructure, key transport systems, key technology and critical equipment manufacturing sectors, which may affect national security.

An acquisition by a foreign investor of a PRC enterprise includes an acquisition of assets from a PRC incorporated enterprise for the purpose of establishing a foreign invested enterprise (“FIE”), an acquisition of interests in a PRC domestic enterprise, an acquisition from Chinese shareholders or equity holders of, or subscription of new shares or equity interests in, an existing FIE incorporated in the PRC.

A “controlling interest” is defined under the Circular as including a foreign investor (including its affiliates), either alone or in aggregate with all the other foreign investors, holding a 50% or more interest in an enterprise or having actual control over the target’s affairs, such as its business decisions, finance, human resources and technology functions.

As in other cases, this test has the potential to be interpreted broadly and to capture both significant and arguably less significant acquisitions. In addition, since interpretation of certain terms will be largely subject to the discretion of the authorities, for example terms such as the “surrounding area of important or sensitive military facilities”, the “importance to national defence security” and “key (sectors)”, there is inherent uncertainty as to when a transaction will be the subject of a national security review.  

Launch of review process

A national security review can be initiated by the relevant government agencies or following an application from the relevant foreign investors, national industry associations, and enterprises operating within the same industry as the target, or within the upstream or downstream industries of the target. 

Focus of review

The security review will assess the impact of the acquisition on (i) national defence, productivity, supply capabilities, (ii) operational stability of the PRC economy, (iii) social order and (iv) research and development of the PRC’s technologies key to national security. No details have been given, however, as to what considerations are to be taken into account in assessing these issues.

Security Review Ministerial Committee

The State Council will set up a Ministerial Committee to oversee mergers and acquisitions of PRC enterprises by foreign investors and to review cases submitted to it by the MOC. The Ministerial Committee will be jointly headed up by the National Reform and Development Commission and the MOC, together with the ministries relevant to a particular transaction.

Review procedure and timing

An applicant must submit any transaction which may have a security impact to the MOC for review. The MOC will in turn submit the application to the Ministerial Committee for review if it deems necessary.

The review by the Ministerial Committee is divided into two phases, a general review  and a special review phase. In the general review phase, the Ministerial Committee will consult the relevant authorities on the impact of the transaction. If no objection is raised by the relevant authorities, the Ministerial Committee will grant approval for the transaction. In the case of any objection, the review will move to a special review phase with the Ministerial Committee undertaking a further assessment. If there is a material disagreement among different authorities on the impact of the transaction, the Ministerial Committee will submit the matter to the State Council for a final decision.

Whilst the Circular does not set out specific timings for an application for security review, investors would be well advised to submit any application as early as possible. The review procedure can take up to 35 working days where only a general review is involved, and up to 100 working days in the case of a special review. No specific timing is set out in the Circular where the review is subject to the State Council’s final decision. This will obviously add another layer of bureaucracy to the approval process for foreign investment and become another headache for foreign investors who are already subject to the existing lengthy and uncertain approval process.

Review decision

To the extent that a potential transaction is found to have caused or may cause a material threat to national security, the Ministerial Committee will request the MOC (together with other relevant authorities) to cancel the transaction, or request the investors to take remedial action, including transfer of the foreign held interests or assets, or take others actions to eliminate any threat to national security.

This leaves open the question as to whether the MOC’s remit extends to reviewing existing investments approved before the Circular takes effect on 5 March 2011 and, in the absence of more detailedrules on the point, remains to be tested.

Separately, although the Circular does not come into effect until 5 March 2011, and whilst not expressly provided under the Circular, it would be advisable for a foreign investor to submit a security review application with the MOC for any acquisition in a sensitive sector where a sale agreement has already been executed but a PRC regulatory approval is still awaited.

Investment in financial institutions

The Circular does not apply to acquisitions of PRC financial institutions by foreign investors, which will be the subject of separate regulations yet to be published.

If you would like to discuss anything regarding this Alert please contact Fang Jian (Shanghai), Nicola Mayo (Shanghai), Simon Poh (Shanghai), or Betty Yap (Hong Kong).