An internal memo from the China Securities Regulatory Commission has thrown the future of the variable interest entity into doubt. With this, and new requirements for a national security review and anti-monopoly review, China is erecting new barriers to inbound mergers and acquisitions. By Alice Gartland

The inbound M&A landscape has changed. It’s a “more difficult environment for foreign investors,” says Robert Woll, a partner at WilmerHale in Beijing. And it’s characterized by a more conservative approach.

Global economic and political troubles continue to strengthen the PRC’s position vis-à-vis the rest of the world and “the PRC no longer needs foreign capital in the same way,” says Woll.

China is focused on becoming “a global leader in high technology and innovation,” says Sven-Michael Werner, a partner at Taylor Wessing in Shanghai, and this is shaping foreign investment law and policy in a way that can seem like bad news for foreign investment.

The end of the VIE?

In August, someone in the research department of the China Securities Regulatory Commission (CSRC) prepared a memo on the future of the variable interest entity (VIE). VIE is an investment structure that has been used by foreign parties to invest in industries in China in which foreign investment is restricted or prohibited.

VIE has become standard practice in the media, the internet, telecommunications and education. It “allows foreign capital to be injected into a company that would otherwise be restricted from receiving foreign investment,” says William Zheng, a partner at Blank Rome in Shanghai. The CSRC memo notes that many Chinese internet companies, including portal Sina, search engine Baidu and YouTube competitor Tudou, have used the VIE structure to attract foreign investment and ultimately to list overseas.

Under the VIE structure, a Chinese operating company is established in China by PRC nationals. This company holds the licences and permits necessary to do business in a sector that is wholly or partially closed to foreign investment. The Chinese owners of this company then invest alongside the foreign investor in an offshore holding company, and that holding company establishes a wholly foreign-owned enterprise (WFOE) in China as a wholly owned subsidiary. The Chinese operating company and the WFOE then sign a suite of agreements that give the WFOE operational control over, and economic benefit from, the Chinese operating company. These typically include profit transfer agreements, loans, share pledges, call options and proxy voting rights. The control and economic benefit that the WFOE enjoys can be equivalent, or nearly equivalent, to those that the foreign investor would have enjoyed if it had been permitted to invest directly in the sector (see diagram).

Although only a draft, the CSRC memo appeared on the website of the Economic Observer ( at the end of last month. It takes a hard line against the VIE structure, and voices a strand of opinion in the government that VIE poses a risk to China’s national security.

According to Seung Chong, a partner at Proskauer in Hong Kong, while there have been periodic crackdowns on the use of the VIE, there has also been “tacit acceptance” of the structure. Ulrike Glueck, managing partner of CMS China in Shanghai, says that “until now the competent authorities did not strictly scrutinize and impose punitive measures”.

However, the official stance is clearly hardening. Luo Chuanwei, a senior partner at Bastion Law Firm, points out that on 20 September, Shen Danyang, a spokesperson at the Ministry of Commerce (MOFCOM), said at a press conference that MOFCOM will discuss with relevant departments how to regulate and standardize the practice of the VIE structure.

The authorities have largely turned a blind eye to the use of the structure for internet companies, which have few tangible assets. But the CSRC memo notes that the structure has increasingly been adopted by traditional industrial companies such as Rongsheng Heavy Industries and Xiangyu Dredging, both listed in Hong Kong. The memo asserts that the listing outside the mainland PRC of companies such as this, with tangible industrial assets, may be seen as a threat to China.

Never safe

Is the VIE structure still safe? In the light of the draft memo, it seems safe to say that it isn’t.

“The VIE structure has never been safe, to the extent that it is used to circumvent regulatory restrictions or prohibitions,” says Sun Hong, a partner at Norton Rose in Shanghai. “It is not such a great thing if a legal system has grey areas which allow bullish people to take advantage of them. It makes little sense for regulations to define areas of activity which are not permitted on the one hand, and leave doors open allowing people to structure around them on the other hand,” continues Sun. “A clear-cut message of yes or no from regulators to the market would be more helpful.”

Seung Chong

But for parties wishing to invest, or attract investment, in restricted sectors, VIE may still be the only way. “There is no real alternative if the investor wants participation as well as control” in a restricted sector, says Chong.

Some comfort comes from reports that vice-premier Wang Qishan is understood to have written a directive about VIEs to the effect that existing ones should be grandfathered and acknowledged as legitimate. Woll points out that the authorities “tend to be good at grandfathering things”.

The VIE structure

The national security review

Concerns over national security have also led to the recent introduction of a national security review (NSR) of M&A transactions.

The NSR “gives the authorities the power to block foreign investment that may have a material impact on national security,” says Marc Waha, head of the Asia competition practice at Norton Rose in Hong Kong.

The review was introduced by the Establishment of a Security Review System for the Merger and Acquisition of Domestic Enterprises by Foreign Investors Notice (Guo Ban Fa [2011] No. 6). The Notice, issued by the General Office of the State Council, took effect on 5 March and was accompanied by the Matters Related to Implementing the Foreign Investors Merging With or Acquiring Domestic Enterprises Security Review System Interim Provisions (MOFCOM announcement No. 8 of 2011). (See China Business Law Journal volume 2 issue 4) The latter provisions expired on 31 August, and were replaced by the Implementation of a Security Review System for the Merger and Acquisition of Domestic Enterprises by Foreign Investors Provisions (MOFCOM Notice No. 53 of 2011), which put the NSR on a permanent legal footing.

The NSR has added another layer of complexity to an already cumbersome approval process for any foreign merger or acquisition, which also includes an anti-monopoly review (AMR) under the still-new PRC Anti-Monopoly Law (see The anti-monopoly review: practitioners’ insights ). As well as being burdensome in itself, the NSR is also linked to the future of the VIE structure.

Article 9 of Notice 53 states that it will be the substance, not the form, of a transaction that will determine whether it falls within the scope of the NSR. It also explicitly says that foreign investors may not circumvent the NSR “by means, including without limitation, nominee shareholders, trusts, multi-level reinvestment, leases, loans, control by agreement or offshore transaction”. This sentence, and in particular “control by agreement”, is thought to catch the VIE.

Some lawyers believe that VIE structures in themselves will not automatically trigger the NSR. “Literally speaking, only those VIE structures which fall under the scope of the national security review” would need to report to MOFCOM, says Charles Li, a partner at Han Kun Law Offices in Beijing. Li says informal consultations with provincial branches of MOFCOM support this view.

However, Woll views references to control in the NSR as the first time there has been specific legislation that could formally bring VIE structures within the purview of the regulatory authorities.

Notice 53 may be applied to a transaction that “has already caused or may cause” a material impact on national security, giving rise to the risk that the NSR could be applied to VIEs retrospectively. However, given that VIEs are pervasive and underpin a number of “national champions” like Baidu, it seems “unlikely that existing VIE structures would be unwound by MOFCOM” says Thomas Man, a partner at Orrick in Beijing. People are nevertheless “taking a look at their risk portfolios”, says Edward Radcliffe, a partner at M&A advisory boutique Vermilion Partners.

So is there still a place for the VIE? David Huang, an associate at Dorsey & Whitney in Shanghai, gives the example of education, which is a restricted area where a foreign investor would need to use the VIE structure to gain access. This should not in theory trigger the NSR, because education appears to be outside the scope of the review.


Top 15 international law firms by number of inbound M&A deals

Although it feels like the NSR has “come out of the blue,” says Werner, “there were clues.”

Before Notice 53, article 12 of the Acquisition of Chinese Enterprises by Foreign Investors Provisions and article 31 of the PRC Anti-Monopoly Law provided for the review of transactions on the basis of their impact on “national economic security” and “national security”, respectively.

However, these provisions lacked detail and the new NSR marks a shift to a “formalized process,” says Geraldine Johns-Putra, a senior foreign legal consultant at Minter Ellison in Hong Kong. “And why not?” asks Johns-Putra. “Other jurisdictions have them.”

Top PRC law firms by inbound M&A deal value

The ambitions of a number of Chinese companies have been frustrated by the national security review mechanisms of other countries.

In February the Committee on Foreign Investment in the US recommended that Huawei Technologies abandon its acquisition of sever patents from 3Leaf Systems on national security grounds. Uncertainty over Huawei’s relationship with the Chinese military is thought to be the reason for the recommendation. And in Australia, although the deal was ultimately rejected by the Rio Tinto board before it could be put before that country’s Foreign Investment Review Board, Chinalco’s attempt to increase its shareholding in Rio Tinto in 2009 generated significant public debate as to whether the deal should be blocked on grounds of national security.

It is, therefore, perhaps not surprising that China has instituted its own review. The fear the NSR gives rise to, however, is that government authorities may use it as a protectionist tool spuriously to block deals they don’t like.

Top PRC law firms by number of inbound M&A deals


The legal provisions relating to the NSR remain “ambiguous,” which gives MOFCOM a large amount of “discretion,” says Wu Peng, a partner at Zhong Lun Law Firm in Beijing.

The notion of national security given in the State Council Notice is broad and includes where a transaction will have an impact on (i) national defence security; (ii) the stable operation of the national economy; (iii) social order; and (iv) key research and development capabilities concerning national security.

The list of industries to which the NSR will apply is also vague. It includes the merger or acquisition by foreign investors of: (i) military and defence-related businesses; and (ii) key domestic enterprises, such as those dealing in important agricultural commodities, important energy and resources, important infrastructure, important transport services and critical technology and assembly manufacturing.

David Yu

David Yu, a partner at Llinks Law Offices, says the scope of the industries covered by the review “needs further clarification” and “it is difficult for companies to judge whether they need to submit an application.”

It needs to be “more specific”, agrees Charles Li, a partner at Han Kun Law Offices.

Kenneth Zhou, a partner at WilmerHale in Beijing, identifies lack of clarity as the “fundamental problem” with the NSR and describes how it has left companies and officials unsure as to when it will apply.

According to several lawyers, MOFCOM has circulated internal guidance on the industries to which the NSR should apply. The guidance, which has not been made public, is said to list up to 60 ndustries such as retail, medical devices and electronics.

Ken Dai, a partner at Dacheng Law Offices, believes a detailed list may be published in the next few months.

Actual control?

A merger or acquisition involving a key domestic enterprise will only trigger the NSR where the transaction results in the foreign investor taking “actual control” of the target. Luo sees the issue of control as key to determining the outcome of the review.

Control is broadly defined and includes factors such as voting rights and situations resulting in “the transfer of actual control rights (such as business strategy, finances, human resources and technologies)” of the target.

Man gives the example of a pending transaction in which the foreign party will take a minority interest in an equity joint venture (EJV). “The EJV implementing rules list four matters for which board unanimity would be required, giving the minority investor effective veto power over such matters,” he says. “The local MOFCOM claimed that expansion of the list of items requiring unanimity would render the project subject to the national security review.”

At an M&A conference in September, Zou Ji, managing partner of Allen & Overy in Shanghai, cited another example. Korean energy company SK Group increased its interest in China Gas Holdings (CGH) to 9.68% between 2007 and 2011. This increase has prompted calls for the NSR to be applied. According to Zou’s presentation, “four high-profile Chinese law professors jointly released a legal opinion on 22 May 2011, pointing out that the control right of CGH had already been transferred from domestic shareholders to SK Group and expressed the view that the transactions should be subject to national security review”.

It‘s “not unusual” for there to be uncertainty in the early stages of implementation, says Dai. And as with the anti-monopoly review, people will “look for examples to guide them”, says Zheng.

Many lawyers are briefing clients on the process and know that it will be an issue for coming transactions, but as yet, few have first-hand experience of the review. Indeed, many lawyers have been keen to avoid being the first to go through the process.

Several practitioners also told China Business Law Journal that they were uncomfortable discussing the process of dealing with the regulators, because they feared it could prejudice their work in this area.
Despite this, real examples of the NSR being used in practice have begun to emerge (see The national security review in practice on page 25).

The national security review in practice

While these are still early days, examples of the national security review (NSR) being applied to proposed M&A deals are beginning to emerge.

Wu Peng, a partner at Zhong Lun Law Firm in Beijing, gives the example of a client proposing an acquisition in the luxury retail sector. The client’s initial view was that the transaction would not fall within the scope of the NSR. However, the local bureau of industry and commerce requested that the client make an application. “The transaction was therefore suspended pending the review,” says Wu.

The lack of detail in the provisions governing the NSR and the fact the review was so new “caused considerable difficulties for the client”.

Wu used Zhong Lun’s “established” communication channels with MOFCOM to prepare the application materials and “the client passed the review in a period of slightly more than one month”.

Wu PengThe NSR legislation does not suggest the retail sector is within the scope of the NSR, but Wu believes that “retail may fall into the scope of the review, according to MOFCOM’s internal guidance”.

Kenneth Zhou, a partner at WilmerHale in Beijing, gives another example.

Zhou worked with a medical device manufacturer whose transaction was signed shortly after the General Office of the State Council issued the Establishment of a Security Review System for the Merger and Acquisition of Domestic Enterprises by Foreign Investors Notice (Guo Ban Fa [2011] No. 6). The transaction was held up at the local level, where officials felt it could be subject to the NSR.

“The way we finally resolved this issue was not to go to MOFCOM to get an approval, which could have taken months, but to try and deal with this at a local level,” Zhou explains. His client “had a number of meetings with the local bureau and explained the wider investments it was planning in the city,” and was able to use this as “leverage to push this deal through”. As a result the client got agreement at the local level that the transaction did not need to go MOFCOM for an NSR.

Ken Dai, a partner at Dacheng Law Offices, helped a client investing in the agricultural sector through the NSR.

The client was acquiring a 20% interest in the target and the transaction documents did not appear to give the client “control”. However the local bureau of MOFCOM was apprehensive that the transaction might still fall under the scope of the NSR, and reviewed it accordingly. The client passed the review.

These examples appear to reflect caution and possible confusion in the application of the NSR at a local level.

But as Dai points out, just as caution may mean the NSR is applied to a broad range of transactions, officials are also likely to be cautious about using it to block a transaction: no one wants to set a difficult precedent.

Local variation in application is another concern. Different provinces will also have different agendas. “Our fear is that certain provinces may require [NSR] approval and not others”, so it is important to “use local consultations, to make sure if it applies”, says William Zheng, a partner at Blank Rome in Shanghai.

A formal pre-filing consultation mechanism exists. This is limited to questions of procedure, but may be more than that in practice. However the result of any consultation is non-binding and has no legal effect.

Security review applications have the potential to last two to four months or beyond and could have a significant impact on the timetable of a transaction. Also, the NSR, anti-monopoly review, and standard foreign investment review cannot run in parallel. This makes the process “disruptive,” says Francois Renard, a partner at Allen & Overy in Beijing, and gives it the potential to significantly delay or even deter a transaction.

The anti-monopoly review: practitioners’ insights

Sven-Michael Werner, a partner at Taylor Wessing in Shanghai, says law firms reacted quickly to the introduction of the anti-monopoly merger review (AMR) with many moving anti-trust experts from other jurisdictions to their China offices. Francois Renard, a partner at Allen & Overy in Beijing, says that although the timeframe for the review may be longer than for similar reviews in other jurisdictions, many of the issues that arise are the same.

“Most transactions have been cleared by MOFCOM except for a number of transactions cleared with ancillary conditions,” says Ulrike Glueck, managing partner of CMS China. The only one that has so far been prohibited was the acquisition of Huiyuan Juice by Coca Cola (see also Diageo buys into baijiu on page 33).

People are becoming “more and more familiar with the regulator,” says Johnny Lam, head of M&A at Walmart China in Shenzhen.

However, there remains a question over whether the AMR has been equally applied to foreign and domestic companies. One lawyer who declined to be identified said there is little consistency in the application of the rules.


Marc Waha, a partner at Norton Rose, describes how despite the publication of rules to clarify MOFCOM’s procedures for enforcing the AMR, “clients still face important uncertainties about MOFCOM’s procedures and substantive analysis”.

The time limits for a merger review are 30 days for the initial review plus 90 days for further review, if required; in exceptional cases the further review may be extended for a further 60 days. However the initial review only begins after MOFCOM is satisfied with the completeness of the information provided; the period of pre-review verification and information requests is not subject to any time limit. Moreover, says Waha, “in practice, MOFCOM has broad powers to claim that the notification is incomplete and halt the review.”

David Huang, an associate at Dorsey & Whitney in Shanghai, has noticed an increase in the number of transactions going to the second phase, but says the reasons behind that remain unclear.

To mitigate the risk of such delays, MOFCOM allows notifying parties to conduct pre-notification consultations.

However, Renard says that the officials who handle pre-notification consultations are not necessarily the ones who make the final decisions. They are often cautious and can be reluctant to take a position on the substance of a transaction until filing actually occurs.

Be prepared, be proactive

The key is to be prepared and “spot the issues early,” says Ken Dai, a partner at Dacheng Law Offices. The AMR should be considered “when contemplating the deal structure and formulating the transaction schedule”.

Glueck agrees: “Fit the merger control review process into the whole transaction schedule and prepare the merger filings as early as possible.” Thomas Man, a partner at Orrick in Beijing, says applicants should “strictly follow the procedural rules”.

For Werner “nothing is more important than having tight coordination of documents and information”. If a number of filings are required, they should be “coordinated centrally”.

Seung Chong, a partner at Proskauer in Hong Kong, also sees “coordinating the timing” and the “consistency” of filings as “critical”.

Collecting market data in China to support an AMR filing can be challenging. “Internet websites and trade associations can yield useful information, but there are limitations,” says Man. Dai says “it is often difficult to obtain data from public sources like the National Bureau of Statistics” so engaging a reputable market-research firm to collect such information may be an option.


Diageo buys into baijiu

One of the landmark deals of the last year was Diageo’s acquisition of a 4% stake in Sichuan Chengdu Quanxing Group, bringing its total holding to 53%. The acquisition made Diageo the indirect controlling shareholder of Sichuan Shuijingfang Company, the Shanghai-listed producer of Shuijingfang, a well known white spirit.

Diageo has applied for CSRC approval to launch a mandatory takeover offer for the outstanding shares in Sichuan Shuijingfang at a price of RMB21.45 (US$3.37)per share. If all the other shareholders in Sichuan Shuijingfang accept this offer, the amount payable by Diageo would be around RMB6.3 billion.

The acquisition of famous brands by a foreign company can be a sensitive issue. In 2009, the attempted acquisition by Coca-Cola of Huiyuan Juice, a Chinese fruit-juice producer, failed to pass the anti-monopoly review and was blocked. Although that decision was based on concerns that Coca-Cola would be able to use its position in the carbonated drinks market to restrict competition from fruit juice manufacturers by bundling products or using other forms of exclusive dealing, it also led to accusations of protectionism, and criticism that neither brand managed the deal process effectively.

There were no anti-monopoly issues involved in the Diageo transaction, but the high-profile acquisition of such a prominent Chinese brand by a foreign company was symbolic.

The deal was announced during UK prime minister David Cameron’s visit to China in June, which was perhaps an indication of the high level lobbying and communication that had been required to push the deal through.

Edward Radcliffe, a partner at the boutique M&A advisory firm Vermilion Partners that advised Diageo, said it was a “difficult transaction because it’s first time a foreign company has acquired a premium white spirits brand” and there was “obviously cultural sensitivity” associated with that.

It was a deal that didn’t happen overnight and was the product of a long term partnership.

“Don’t forget, Diageo spent five years working in a joint venture with them,” says Radcliffe. “They worked on numerous initiatives to help Shuijinfang go overseas, such as work on product and packaging, and worked together to innovate new products for the China market, such as the vodka Shanghai White.”

It is often said that the Chinese side in a business deal want to see a demonstration of full commitment from the foreigners. There was “no doubt” about that in Diageo’s case, says Radcliffe.