China’s new venture capital regulations provide limited improvements for investors
As year two of China’s World Trade Organization (WTO) membership rolls on, China continues to open its financial services sector to foreign investors. On January 30, 2003 the Ministry of Foreign Trade and Economic Cooperation (MOFTEC-now the Ministry of Commerce [MOFCOM, see p.26]), Ministry of Science and Technology (MOST), State Administration of Industry and Commerce (SAIC), State Administration of Taxation (SAT), and State Administration of Foreign Exchange (SAFE) jointly issued the Regulation on the Administration of Foreign-Invested Venture Capital Enterprises (the regulation).
The regulation encourages investment in China’s high-technology sector and aims to further develop China’s venture capital (VC) investment regime. The regulation covers the creation, operation, and dissolution of foreign-invested venture capital enterprises (FIVCEs), defined as foreign-invested enterprises (FIEs) engaging in venture capital activities. Article 3 of the regulation defines VC activities as investing in the equity of nonlisted high-tech companies, providing VC management services, and earning capital gains over time. A FIVCE must have “venture capital” in its name. The regulation, which took effect March 1, 2003, replaces the ineffective 2001 Provisional Regulation on the Establishment of Foreign-Invested Venture Capital Investment Enterprises (provisional regulations). Many aspects of the provisional regulations, good and bad, reappear in the regulation. An overriding concern, from the perspective of foreign VC firms, is that FIVCEs remain subject to some degree of government interaction and direction.
Forming a FIVCE
The revised FIVCE structure is a welcome development for foreign venture capitalists, though the regulation imposes some frustrating limitations. Investors have some degree of flexibility in choosing the FIVCE’s structure, although a wholly foreign-owned enterprise will likely be the most popular of the FIVCE structuring options. The regulation divides possible structures into nonlegal person and corporate categories-each with its own requirements and procedures. For example, investors in nonlegal person FIVCEs have unlimited liability, while corporate FIVCEs have capped liability. Nonlegal person FIVCEs may elect to have investors pay tax separately at the investor level or to be taxed at the FIVCE level, while corpo-rate FIVCEs are subject to PRC tax on investment returns and gains (though dividends received are currently tax exempt, provided that both issuer and recipient have FIE status).
FIVCEs must have between two and 50 investors, including at least one “principal investor.” The principal investor serves as the FIVCE’s manager, and must be an experienced venture capitalist that has overseen $100 million in investment (of which at least $50 million must be VC-focused) during the three years prior to the FIVCE’s creation. A Chinese principal investor must have overseen Y100 million ($12.08 million), of which at least half was VC- focused during the three years prior to the FIVCE’s formation. Principal investors must employ at least three professional management staffers, each with at least three years of VC experience and each without a disciplinary record in their home jurisdiction. A principal investor in a nonlegal person FIVCE must contribute more than 1 percent of the entity’s aggregate capital; a principal investor in a corporate FIVCE must contribute more than 30 percent of the entity’s aggregate capital. To satisfy these requirements, a potential principal investor may aggregate its experience and capital contributions with those of its affiliated entities.
Each nonprincipal FIVCE investor must contribute at least $1 million. Aggregate capitalization from all nonprincipal investors must exceed $10 million in a nonlegal person FIVCE and $5 million in a corporate FIVCE.
Principal and nonprincipal investors in a nonlegal person FIVCE may make capital contributions in installments extending up to five years after formation. Existing regulations affecting corporate FIVCEs, such as regulations on equity joint ventures, specify capital contribution timing for those entities.
In addition to quantitative requirements, FIVCEs themselves must satisfy certain qualitative requirements, such as having appropriate formation documents and employing more than three professional staff members with experience in VC investment (unless the FIVCE entrusts its management to a venture capital investment management enterprise [VCIME]; see p.27).
FIVCEs must have a management committee to represent and protect investors’ interests: a joint management committee for a nonlegal person FIVCE and a board of directors for a corporate FIVCE. This management committee, in turn, must establish an office to manage the FIVCE’s daily operations. Operational management office staff must have full civilian status, no criminal record, and appropriate VC experience. Alternatively, a FIVCE may delegate its operational management responsibilities to a VCIME or another FIVCE.
Low liquidity and restrictive timing
Foreign investors forming FIVCEs will find that the regulation imposes several cumbersome requirements. For example, most foreign VC investors may have a difficult time reducing their capital contribution or changing investment status during the FIVCE’s term. A nonlegal person FIVCE’s formation documents may specify capital contribution reduction procedures for non-principal investors, but any such reduction requires the consent of investors holding more than 50 percent of the value of the FIVCE’s aggregate capital and the consent of each principal investor. A principal investor in a nonlegal person FIVCE may not reduce its capital contribution during the FIVCE’s term except in unusual circumstances. Such reduction depends on the principal investor obtaining the consent of the FIVCE investors that hold more than 50 percent of the value of the FIVCE’s aggregate capital; transferring its interest to a qualified assignee principal investor; revising the FIVCE’s formation and operational documents; and obtaining MOFCOM approval. The regulation prohibits any capital contribution reduction that would cause the FIVCE’s aggregate capital to fall below $10 million. Existing regulations cover capital contribution reductions for corporate FIVCEs.
New nonprincipal investors in any FIVCE must satisfy conditions in the regulation and in the FIVCE’s formation documents, must obtain the consent of the principal investor and MOFCOM, and must have the FIVCE’s formation documents amended. A nonprincipal investor in a nonlegal person FIVCE may assign its FIVCE interest without following the above-mentioned steps, as long as the assignee satisfies conditions in the regulation and the FIVCE’s formation documents.
Another shortcoming of the regulation is that the application and registration periods for both FIVCE formation and investments by a FIVCE are too long. If government entities abide by the letter of the regulation, it will take more than 60 days to form a FIVCE. Founders must submit an application to the provincial-level MOFCOM office (based on the FIVCE’s proposed location). The provincial- level office must examine the application materials and report to central-level MOFCOM within 15 days of receipt of the application materials. Central-level MOFCOM then has 45 days from receipt of materials from the provincial-level MOFCOM to review, and approve or reject, the FIVCE’s application. MOST must also consent before formal approval is granted.
Approved FIVCEs will receive written notification of approval and an FIE Approval Certificate that they must submit, along with other items, to the appropriate SAIC office for registration within one month of receipt. Upon SAIC approval, nonlegal person FIVCEs will receive Business Licenses, and corporate FIVCEs will receive Legal Person Enterprise Business Licenses.
Restrictions on investment and operational scope
Foreign investors will discover additional concerns when reading the regulation’s restrictions on FIVCE investment and operational scope.
* FIVCEs are not permitted to invest in more than “plain vanilla” equity, nor may they invest in varying classes of preferred stock, quasi-equity such as equity warrants (available in Hong Kong) or varying classes of convertible debt.
* FIVCEs may not make investments through loans or any funds other than the FIVCE’s own funds, or provide credit or guarantees (excluding investment in bonds issued by an investee company or convertible bonds with a term of at least one year). Further, FIVCEs may not lend an unrestricted amount to their investee companies, even though such lending could result in closer alignment of goals between the FIVCE and its investee company.
* As stated above, a FIVCE may only invest its own funds in unlisted equities, provide VC investment consulting, provide management consulting to investee enterprises, or engage in other operations as approved. FIVCE investment into target entities must comply with the Catalogue Guiding Foreign Investment in Industry and the Regulation on Guiding Foreign Investment Direction. A FIVCE may not invest in projects that the catalogue lists as prohibited; directly or indirectly invest in listed securities (except when the FIVCE invested before the investee’s initial publ\ic offering); directly or indirectly invest in fixed assets that are not for the FIVCE’s own use; or invest in other projects as prohibited by laws, regulations, or the FIVCE’s formation documents.
* FIVCE investments, and increases and transfers thereof, are subject to approval and registration requirements and potentially long timelines. When investing in an encouraged or permitted category entity, the FIVCE must notify the local-level MOFCOM where the investee is located. The local MOFCOM office must conclude its review and, if it approves, issue an FIE Approval Certificate within 15 days after receiving the completed application materials. FIVCEs investing in a restricted category entity must notify the local- level MOFCOM where the investee is located, although the local MOFCOM has 45, not 15, days to review the investment application. Upon approval the investee must file its FIE Approval Certificate with SAIC, which will issue an FIE Legal Person Enterprise Business License. A FIVCE must report to MOFCOM within one month of completing any portfolio investment. As service sectors open to foreign investment, FIVCE investments will be examined and approved according to relevant, and new, regulations.
Investee enterprises will enjoy FIE incentive treatment only if aggregate foreign investment (from a FIVCE or otherwise) exceeds 25 percent of the entity’s registered capital. An existing domestic natural person enterprise that receives foreign investment and is eligible to become an FIE may retain its original domestic natural person investor’s status.
Problems with profits and payments
As specified in the regulation, a FIVCE’s profits are primarily to come from the disposition of its equity interests. A FIVCE may dispose of such interests by selling to other investors; entering into a repurchase agreement with the investee; transferring its interests via the stock markets after the investee publicly lists; or other methods as specified by relevant Chinese laws and regulations. Resale of equity interests held by a FIVCE should be, but is not, allowed automatically when both parties to the transaction are FIVCEs. MOFCOM and SAIC are drafting rules on repurchase agreements between a FIVCE and an investee company.
Nonlegal person FIVCEs may distribute investment gains as provided in their formation documents and as consistent with “international norms,” a term left undefined in the regulation. Proceeds from such equity sale by a nonlegal person FIVCE may be distributed directly to the investors and be regarded as a reduction of their capital to the extent that such proceeds are less than an investor’s original investment.
The nonlegal person FIVCE must file a notice on the distribution and related capital reduction with MOFCOM and SAFE 30 days before the proposed distribution. This notice must show that the nonlegal person FIVCE’s remaining capital exceeds outstanding investment liabilities. The regulation does not specify whether such distribution is subject to approval. SAFE is expected to issue new regulations on this distribution process in the near future. Distributions by corporate FIVCEs are subject to existing regulations.
Though VC investors would prefer that there be no restrictions on the repatriation or transfer of gains, the regulation’s foreign exchange process imposes burdensome transaction costs on FIVCEs that repatriate profits. A FIVCE must submit several documents to its foreign exchange bank prior to offshore distribution of profits or other payments. These documents include the management committee’s resolution approving the distribution or payment, an auditing report, proof of and inspection report on the funds injected by the foreign investors, and proof of tax payment and tax examination reporting form issued by an accounting firm. Profits may be used to purchase foreign exchange for repatriation consistent with relevant laws and regulations. A corporate FIVCE’s foreign exchange account, capital distribution, and other foreign exchange receipt and expenditure items are subject to existing foreign exchange management regulations. SAFE is currently drafting foreign exchange regulations for nonlegal person FIVCEs.
As with the provisional regulations, the regulation specifies that FIVCEs are to be taxed according to relevant laws and regulations. FIVCE funds thus are at a disadvantage since more tax- efficient structures are possible using offshore or tax haven structures. Ideally, a FIVCE could pass gains and losses to its investors and its affiliates without incurring taxes, deduct losses generated by investments against gains, and deduct financing costs associated with VC investments. Corporate FIVCEs must submit one comprehensive corporate tax payment. A nonlegal person FIVCE may allocate its tax liability to its individual investors as provided in its operational documents-as long as such allocation is consistent with relevant tax laws. SAT is drafting further regulations on the collection of taxes from nonlegal person FIVCEs.
Termination and liquidation
A FIVCE’s term must be stipulated in its organizational documents and normally may not exceed 12 years. MOFCOM must approve any extension of the FIVCE’s operating term and must approve a corporate FIVCE’s dissolution prior to expiration. A nonlegal person FIVCE may dissolve before its term expires without prior MOFCOM approval if it has disposed of all of its equity investments, satisfied all debts, and provided for capital distribution. In such a case, the nonlegal person FIVCE must submit a notice of dissolution with MOFCOM 30 days before the proposed dissolution date. FIVCEs must apply to SAIC to cancel their registration within 30 days after completing liquidation. This cancellation package must include a report from the FIVCE’s management committee, a cancellation application, liquidation report, and other documents as required by applicable laws. The FIVCE will be terminated upon SAIC approval, but the nonlegal person FIVCE’s principal investor’s obligations extend past the termination of the venture.
Better, but not good enough
The regulation is an ambitious attempt to nurture China’s venture capital and high-tech sectors. But it fails to correct many problems carried over from the provisional regulations. In addition to the problems mentioned above, the regulation does not sufficiently address investors’ concerns about the transparency and accuracy of an investee company’s books and records-requiring FIVCEs to spend significant time and money on due diligence, thus increasing transaction costs.
Despite this and other flaws, the regulation is a positive step in the development of China’s VC market. The qualitative and quantitative requirements placed on FIVCE investors show that the regulation is aimed at attracting investors with market experience, not purely financial speculators. Greater foreign involvement in this sector will continue to drive regulatory development, and VC rules no doubt will continue to evolve.
The Birth of MOFCOM
Now defunct, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) and the State Economic and Trade Commission were merged into the new Ministry of Commerce (MOFCOM) in March, Although the Regulation on the Administration of Foreign-Invested Venture Capital Enterprises refers to “MOFTEC,” such references have been replaced with MOFCOM throughout this article.
Venture Capital Investment Management Enterprises
The Regulation on the Administration of Foreign-Invested Venture Capital Enterprises introduces a new type of entity, a venture capital investment management enterprise (VCIME), subject to many of the same organizational requirements and processes as a foreign- invested venture capital enterprise (FIVCE). VCIME founders must submit an application to the provincial-level Ministry of Foreign Trade and Economic Cooperation (now the Ministry of Commerce [MOFCOM]) office, based on the VCIME’s proposed location. The provincial-level MOFCOM has 45 days from receipt of the complete application to approve or reject a VCIME’s formation. Upon approval, the VCIME receives a Foreign-Invested Enterprise Approval Certificate that must be registered with the appropriate State Administration of Industry and Commerce (SAIC) office within one month of receipt.
VCIMEs must employ more than three professional management personnel with at least three years of relevant experience each, have registered capital of at least Y1 million ($120,773), and have a complete internal control system. A VCIME’s business scope is restricted to FIVCE management, including the oversight and informational production requirements usually performed by a FIVCE’s board of directors or management committee. A potential management contract between a VCIME in China and a FIVCE is not effective until it is unanimously approved by the FIVCE’s investors and approved by MOFCOM. An overseas VCIME must file a registration application with the relevant SAIC office within 30 days of execution of a management contract with a FIVCE (though such agreement seems to be effective upon execution).
-Michael E. Burke
Michael E. Burke
is an attorney in private practice in Washington, DC. He is a vice chair of the American Bar Association’s China Law Committee and is a fellow at the Asian Institute of International Financial Law at the Hong Kong University School of Law.
Copyright U.S.-China Business Council Jul/Aug 2003
