New Map For Foreign Venture Capital Investments in China

China
The past few months have seen the Chinese Government release of a wide range of new regulations favouring foreign investment in China. These new regulations are designed to respond to China's accession to WTO and the need of sustainable economic development. Among other things, these changes open up more industries to foreign investors, introduce the possibility of establishing foreign-funded venture investment enterprises, and open the door to foreign-invested enterprises ("FIE") listing on China's stock exchanges.

The Door Opens Wider

In February 2002, China's State Council released new Regulations on Foreign Investment Guidelines (the "Regulations"), repealing the 1995 version. These Regulations together with the new Industrial Guidance Catalogue for Foreign Investment (the "Catalogue") in March, 2002, further open the market for foreign investment. The Catalogue classifies projects for foreign investment purposes as "encouraged", "restricted" and "prohibited" with projects not included in the list being treated as "permitted". Generally speaking, projects classified as "encouraged" or "permitted" face fewer obstacles at the approval stage than projects regarded as "restricted" and may be eligible for preferential treatment.

Of a total of 371 items under the new Catalogue, 75 items fall into the restricted category - a substantial reduction from 112 items under the old Catalogue. Sectors such as telecommunications, construction and operation of urban water supply and sewage, gas and thermal energy supply networks that were prohibited previously are now open to foreign investment. However, limits are placed on foreign ownership in these projects. As far as venture capital is concerned, with limited exceptions, new and high technology industries in China are regarded as either "encouraged" or "permitted". For example, in the electronic and communications industries, foreign investment is "encouraged" in the production of 29 specific items of electronic and communications equipment. Satellite navigation and positioning systems and their key components that were "restricted" previously are now "encouraged". Handsets, base stations and switching equipment for GSM, CDMA and other mobile communications systems and digital truck system equipment now all fall within the "encouraged" category.

Under the new Catalogue, 34 items are prohibited for foreign investment e.g. processing of Chinese medicine materials listed as national protected resource (such as musk, licorice root etc), application of preparation techniques for traditional Chinese medicinal drinks and tablets and production of Chinese medicine with secret recipes. No foreign investment is allowed in various sectors of media including radio, film, television and publishing, with limited exceptions.

New Investment Model

Following the issuance of the Tentative Provisions on Establishment of Foreign-funded Venture Investment Enterprises (the "VC Provisions") which came into effect on 1 September 2001, a new investment model is now available for foreign venture capitalists investing in China. Foreign venture capitalists are now permitted to set up in China a corporate vehicle primarily for the purposes of investing in new and high- tech companies in China. Such a vehicle, which is called foreign-funded venture investment enterprise ("FFVIE") under the VC Provisions, is permitted to engage in the following businesses:

> Investing all its own funds in new and high-tech industries and such other sectors as approved by the government;

> Providing consultancy services in relation to venture capital investment;

> Providing management services to its investees; or

> Any other businesses that the government may approve.

A FFVIE is generally prohibited from investing in any securities, options, commodity futures or other financial derivatives or real estate (other than properties for self-use), either directly or indirectly, and it should not take out loans or use funds other than its own capital to make investments.

Exit Options

The VC Provisions provide three clear routes by which FFVIEs may exit their investments in Chinese companies. They include:

> Transfer or assignment of all or part of its equity interests in the investee to other entities;

> Buy-back by the investee of the equity interest held by FFVIE; and

> Initial public offering (IPO) and listing on domestic or overseas stock exchanges.

In the past, only domestically funded companies are eligible to list on China's stock exchanges. PRC government policy did not permit the listing of FIEs in the past. However, the Ministry of Foreign Trade and Economic Cooperation ("MOFTEC") and China Securities Regulatory Commission ("CSRC") issued the Several Opinions Concerning the Listed Companies Involving Foreign Investments (the "Opinions") in November 2001 marking a significant step forward in this area. The Opinions not only provide strong support for the notion that foreign-invested companies are permitted to list on domestic exchanges, but also set out relatively concrete prerequisites and procedures for the listing domestically of new shares or existing unlisted shares issued by foreign-invested companies.

PRC law provides that FIEs must be converted to Foreign-invested Joint Stock Companies ("FIJSCs") in order to list. Apart from the conditions specified in the PRC Company Law and other regulations issued by CSRC that applicable to domestically funded companies, FIJSCs are also required to meet the following additional preconditions for the new issue of shares (either A shares (note 1) or B shares (note 2)) in China:

i. FIJSCs must have passed their annual inspections in the three years preceding the application for listing;

ii. FIJSCs must have their scopes of business in conformity with the foreign investment policies;

iii. the proportion of their foreign-invested shares should account for not less than 10 per cent of the total share capital after the listing;

iv. where the law requires Chinese parties to be controlling shareholders or there is special requirements on Chinese shareholdings, such requirements should be complied with after listing; and

v. the FIJSCs must meet other requirements laid down in the relevant regulations applicable to public issuance and listing of shares.

Where FIJSCs has issued B shares that are unlisted, they may also apply to list such B shares domestically upon the approval of the MOFTEC and CSRC. To be eligible for listing, the unlisted B shares must have been in existence for more than one year after the issuance, and the current holder must hold the B shares for at least one year after the listing of such shares.

Currently, only a limited number of high-tech companies would be able to satisfy the onerous preconditions for listing set out above. However, the result of these recent changes in PRC law would appear to be a move toward providing a more favourable environment for foreign venture capital activities in China.

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Endnotes:

1. "A" shares: Shares that can be bought in the China securities market. They can only be subscribed for, traded in and purchased by domestic investors. "A" shares are denominated and paid in RMB, and dividends are paid for in RMB. They are ordinary shares issued by Chinese companies that are listed on either the Shanghai or Shenzhen Stock Exchange.

2. "B" shares: Shares that can be bought and traded by both domestic and foreign investors. They are subscribed for and traded in Hong Kong Dollars or US Dollars; and denominated in RMB. They are ordinary shares (in parallel with "A" shares) issued by Chinese companies that are listed on either the Shanghai or Shenzhen Stock Exchange.

For more information about Foreign Venture Capital investments in China, please contact Chris Southorn on +852 2846 9137 or chris.southorn@cms-cmck.com. We offer more information about China and the WTO on our website at www.law-now.com.hk