China's Legal Initiative to Spur Venture Capital Investment Xiaohu Ma 11/18/2001 Client Alert Introduction International venture capital funds have been increasingly active in seeking opportunities in China in recent years. It has been recently estimated that more than US$4.2 billion of venture capital was invested in China at the end of the year 2000, representing a 23% increase over the amount invested in the prior year. Moreover, almost all of China's well-known Internet companies, including NASDAQ-listed Sina, NetEase and Sohu, have received investments from offshore venture capital funds. Yet, China's legal framework for foreign investment has traditionally restricted the ability of offshore venture capital funds to operate and directly invest in China and did not facilitate the kinds of exit mechanisms that venture capital funds depend on to realize on their investments. The Chinese authorities have begun, however, to view venture capital funds as a new source of foreign investment and a constructive financing tool and are looking to encourage international venture capitalists to operate directly in China. This is intended to not only bring in more venture capital for China's new and high-tech industries, but also to draw managerial know-how into China so that it can develop its own venture capital industry. As an initial step to pave a legal path for offshore venture capital funds to enter China, China's Ministry of Foreign Trade and Economic Cooperation ("MOFTEC"), the Ministry of Science and Technology ("MST") and the State Administration of Industry and Commerce ("SAIC") jointly enacted Tentative Rules on Forming Foreign-Invested Venture Capital Investment Enterprises (the "Rules") on August 28, 2001. By attempting to reconcile the existing legal framework for foreign investment in China with customary offshore venture capital fund practice, the Rules constitute a significant advance for the venture capital fund industry and should certainly prompt interest among international venture capital fund sponsors and investors. It remains to be seen, however, whether they are a sufficient advance to create a robust foreign-invested venture capital industry in China. This article will explore the manner in which this legal reconciliation has been accomplished and will highlight some of the benefits the Rules provide to international venture capital fund sponsors and investors and the restrictions that still remain. New Rules Framed under Existing Laws Starting in the late 1970's, China promulgated numerous laws and regulations to encourage, maintain and regulate the influx of foreign investments. The Sino-Foreign Equity Joint Venture Law, the Sino-Foreign Cooperative Joint Venture Law and the Wholly Foreign-Owned Enterprise Law constitute the three pillars of the existing legal framework for foreign investment in China. Under this framework, the only vehicles available for foreign investors to invest and conduct business in China, including investment vehicles created under the Rules, are foreign-invested enterprises in the form of Sinoforeign equity joint ventures, Sino-foreign cooperative joint ventures, wholly foreign-owned enterprises or foreign-invested companies limited by shares. In this article, foreign-invested enterprises and the laws governing them are collectively referred to as "FIE's" and the "FIE Laws," respectively.
The FIE Laws were originally designed to attract long-term strategic investors who wanted to engage in a particular business with a Chinese partner. Generally, these joint ventures must operate as a stand-alone enterprise, and they cannot invest more than 50% of their capital in other Chinese companies. Subsequently, in 1995, the Chinese authorities implemented new regulations to allow very large foreign investors to form umbrella holding companies, known as foreigninvested holding companies, to hold multiple Chinese joint ventures that are in related businesses. These holding companies enable qualified foreign investors to coordinate the operational activities of their previously stand-alone joint ventures, such as marketing and distribution, and provide other services to the subsidiaries. From the point of view of the international venture capital community, the key problem with this legal framework is that, although foreign-invested holding companies can invest 100% of their capital in a group of companies and thus resemble an offshore venture capital fund, such holding companies were created specifically for the traditional long-term strategic investor and are, therefore, subject to many restrictions and limitations. These restrictions and limitations are very rigid and not well suited to venture capital funds which commonly spread their risk among different lines of businesses, capitalize on opportunities quickly as they arise and strive to realize a return on their investment within a relatively short period of time. For example, in addition to the restriction that the subsidiary joint ventures all be in the same line of business, liquidating a foreign-invested holding company is a difficult and time-consuming task. Thus, venture capitalists cannot easily exit an investment in a foreign-invested holding company. Although the Rules are framed generally within the boundaries of the existing legal framework for foreign investment (in fact, they specifically state that they were formulated pursuant to those laws, the Chinese Company Law and other applicable laws and regulations), they contain a number of innovative provisions that cannot be found under the FIE Laws. These provisions clearly indicate that Chinese policymakers have heeded the unique concerns of venture capital investors and fund managers and have attempted to address some of these concerns to the extent permissible under the existing legal framework. It is also important to note that, since the Rules are based on the existing legal framework for foreign investment, the basic legal concepts of the Rules differ from those found in customary offshore venture capital fund practice. Thus, for example, the Rules do not use the term "fund." Instead, they refer to "foreign-invested venture capital investment enterprises," and contemplate a variety of investment structures, only some of which are similar to the usual fund structures with which offshore investors are familiar. We believe that in most cases, foreign investors will be most interested in those structures that lend themselves to being operated in the manner of traditional offshore funds. Therefore, for purposes of this article, we have used the term "Foreign-Invested VC Fund" instead of "foreign-invested venture capital investment enterprise." Growing Domestic Venture Capital Industry by Allowing Domestic Investors to Invest Side by Side with Foreign Investors MOFTEC, MST and SAIC specifically provide in the Rules that one of their goals is to help foster China's venture capital industry, which is currently in its infancy. Well-trained and experienced professional investment managers, as well as the myriad of service providers which support their operations such as back-office administrators and stock custodians, are in short supply in China. To encourage these parties to operate in China, the Rules create the first legitimate mechanism for domestic Chinese investors to invest side by side with foreign investors and to have their funds managed by foreign fund professionals by allowing Chinese investors to make investments in domestic currency in Foreign-Invested VC Funds. This ability of Chinese investors to co-invest with foreign investors presents perhaps the most significant benefit of the Rules and contrasts sharply with prior practice under which Chinese companies were effectively precluded by China's foreign
exchange rules from investing in offshore funds (as well as in other offshore investments) without governmental approval, which is difficult to obtain. Yet, in order for foreign investors to team up with Chinese partners and to tap into the potentially large pool of domestic capital in China, they must enter into one of the approved forms of joint venture funds with at least one qualified Chinese partner. Chinese investors are subject to stringent quantitative and qualitative eligibility requirements. For example, at least one Chinese investor must have venture capital investments as its principal business and have accumulated capital under management in the prior three years of at least RMB100 million, or its net asset value at the end of the year prior to applying to form a fund is at least RMB100 million. In addition, the minimum investment of each Chinese investor is US$5 million. In the near term, there will probably be few domestic companies that can comply with these criteria. Competition in finding a qualified strategic Chinese partner may arise among the large offshore fund managers and investors who are interested in gaining access to the domestic capital, which may limit the number of joint venture funds that are established under the Rules. The Rules also impose significant quantitative and qualitative restrictions on foreigners who want to invest in a Foreign- Invested VC Fund, which will limit venture capital activity in China to highly experienced, well-funded foreign fund managers and large, sophisticated foreign investors. For example, at least one foreign investor must, among other things, have venture capital investments as its principal business, have accumulated funds under management of at least US$100 million in the prior three years and make an investment of at least 3% of the fund's total committed capital. Also, at least one foreign investor must invest a minimum of US$20 million with all other foreign investors obligated to invest at least US $10 million. This type of investor screening practice reflects the traditional strategic thinking of the Chinese government in encouraging the introduction of advanced managerial know-how together with foreign investment and limiting investment opportunities only to large international players. Non-Legal Person Joint Venture: A Suitable Corporate Form for Foreign-Invested VC Funds? One of the legal hindrances to the creation of a venture capital fund industry in China has been the absence of a corporate form which has the traits of a limited partnership or U.S.-type limited liability company. These corporate forms are popular for offshore venture capital funds because, among other reasons, the manager and investors have a great deal of flexibility in determining the details of the fund's management structure and operations, including distributions of profits, and they offer limited liability for the passive, non-managing investors. The only vehicles available for foreign investors in China are FIE's, and it is statutorily required that all FIE's take the form of a limited liability company, except for Sino-foreign cooperative joint ventures, which may choose to be non-legal-person entities. [1] However, FIE's that take the form of a limited liability company generally do not offer offshore fund managers and investors the flexibility to which they are accustomed in structuring their funds. To address this fundamental obstacle, the Rules provide that a Foreign-Invested VC Fund may be formed as a Non-Legal Person Sino-Foreign Cooperative Joint Venture (hereinafter referred to as "NLPJV"), in addition to the traditional limited liability company form. According to the Implementing Rules enacted for the Sino-Foreign Cooperative Joint Venture Law, the joint venture partners to an NLPJV enjoy more room to manage their investments in the joint venture at their own discretion, as opposed to a conventional legal person entity which is subject to extensive regulatory requirements. For example, the investments in an NLPJV may be owned individually by respective investors or collectively by all the investors or partial owned individually and partial owned collectively. Given the flexibility of the structure of the NLPJV, the joint venture agreements can be prepared to accommodate offshore venture capital fund practice to the extent possible
under existing Chinese legal framework. In fact, the Rules specifically confirm that investors in an NLPJV may agree among themselves that one investor shall be responsible for all the debts of the fund (like the general partner of a limited partnership), with all other investors being liable for such debts only to the extent of their respective capital contributions (like the limited partners of a limited partnership). It would be difficult to achieve the same result under any of the traditional FIE corporate forms. NLPJV's have been rarely used by investors in China, and the attention devoted to this form in the Rules clearly evidences the policymakers' desire to allow fund managers and investors to follow customary offshore venture capital fund practice as much as possible. Nonetheless, although an NLPJV allows managers and investors to operate their Foreign-Invested VC Fund in many respects like a limited partnership, it may not afford investors all the attributes of a limited partnership, in particular the pass-through tax attributes that are associated with limited partnerships. In addition, investors need to note that an NLPJV's governing documents would have to be quite extensive as to matters such as investors' rights because there is no equivalent to the Cayman limited partnership law to which the investors can refer to or rely upon in this case. Although the flexibility of the NLPJV form should be attractive to offshore venture capital fund investors and managers, it may turn out over time that the other more traditional corporate forms, such as a Sino-foreign equity joint venture or Sinoforeign cooperative joint venture, may also prove useful. For example, some very large offshore funds may wish to take advantage of the benefits of the Rules even if they do not intend to operate a typical venture capital fund in China that would necessitate the flexibility of an NLPJV. One possibility is that an offshore master fund that invests the capital of its affiliated offshore feeder funds may want to team up with a strategic Chinese partner to make direct investments in China. To achieve this goal, the master fund would have to establish a Foreign-Invested VC Fund, but the master fund would have no need for many of the typical features of an offshore venture capital fund if the master fund does not want or need other foreign investors to participate in the Foreign-Invested VC Fund. Further, the master fund's Chinese partners and investors would be more familiar with the traditional limited liability company forms than an NLPJV. Accordingly, the master fund may be inclined to form the domestic fund as a Sino-foreign equity or cooperative joint venture. Alternately, a group of "sister" offshore venture capital funds may wish to pool their capital for direct investments in China but also take advantage of certain benefits available only under the Rules, such as the option to have their investments redeemed by their portfolio companies (which, as discussed in the next section, is an action currently authorized only in the Rules). A Foreign-Invested VC Fund in the form of an NLPJV may be unnecessary here because the offshore funds are all, in effect, the fund sponsors, so there is no need to draft an elaborate set of rights for the fund sponsor, on the one hand, and the fund investors, on the other. Thus, for simplicity's sake, the offshore funds may choose to establish the Foreign- Invested VC Fund in the form of a wholly foreign-owned enterprise. It should be noted that, because the lead foreign investor in a Foreign-Invested VC Fund cannot withdraw from the fund prior to its termination except in very limited circumstances, the foregoing structures would only be appropriate for funds with business plans that contemplate investments in China that would not need to be repatriated for a set period of time lasting at least a few years. Facilitating Portfolio Divestments under the Rules The Rules also make some effort to facilitate divestments by Foreign-Invested VC Funds in keeping with customary offshore venture capital fund practice. In recognition of the fact that most venture capital fund investors are not interested in entering the business of their fund's portfolio companies or fulfilling some strategic business objective, but rather look to achieve a return through capital appreciation, the Rules identify three specific ways a Foreign-Invested VC Fund can
dispose of its portfolio investments: (a) transfer the equity interest in a portfolio company to a third party, (b) cause the portfolio company to redeem its equity interest, and (c) list the portfolio company's securities on a domestic or international exchange. Among these three exit mechanisms, the availability of redemption may be of particular interest to venture capitalists because it constitutes a major departure from existing laws governing foreign investment and represents an entirely new exit strategy for China. Prior to the enactment of the Rules, the legal framework for foreign investment in China provided no legal basis for the redemption of foreign investors' interests in an FIE. For "normal" FIE's (i.e, those not established under the Rules), the only means available for a foreign investor to dispose of its equity interest prior to an initial public offering or liquidation is to sell the equity to a third party. Such sale is subject to government approval. A withdrawal and reduction of the original capital investment of an investor in an FIE is allowed only in highly limited circumstances. Further, even after an FIE converts into a joint stock company (as is required to effect an initial public offering) and completes such an offering, the investor's liquidity will still be limited under Chinese law by a mandatory lock-up requirement. In contrast, under the Rules, an investor in a Foreign-Invested VC Fund may be able to arrange for the portfolio company to repurchase the fund's equity interest at agreed-upon terms and conditions. Since a fund will, in many cases, be in effective control of its portfolio companies, this new mechanism may give a Foreign-Invested VC Fund greater ability to control the timing of its exit from a specific portfolio company. Rather than including guidance as to how the redemption right may actually be exercised, the Rules explicitly state that a separate set of rules covering this area will be formulated in the future. Therefore, for example, it is unclear at this stage whether the redemption can be exercised at a premium value. Yet, even if a redemption could be made at a premium, it is likely that a fund will achieve a superior valuation and overall return if it sells its equity to a third party or the portfolio company lists its securities. Accordingly, these new redemption rights may ultimately be most useful for limiting losses in unsuccessful investments, particularly in situations where the portfolio company still retains some funds to make the repurchase. Remaining Road Blocks for Venture Capital Investment in China Because a Foreign-Invested VC Fund is considered to be a foreign company despite the fact that it is domiciled and operated in China and may have Chinese investors, the formation and operation of such a fund remains to a great extent subject to the detailed restrictions imposed by the FIE Laws and the related regulations on foreign investments, such as the requirement that each portfolio investment must be approved by the relevant FIE approval authorities. Notably, in addition to this government approval requirement, the Rules require that, within one month after obtaining the approval for each of its portfolio investments, the fund must make another filing with MOFTEC concerning such investment, failing which the relevant approval will be invalidated. This mechanism for invalidating investment approvals is unique under the Chinese legal framework concerning foreign investments, and its underlying purpose remains unclear. Most likely, MOFTEC simply wants assurance that it will receive timely information regarding the investing activity of Foreign-Invested VC Funds. Further, whatever its corporate form, the formation of a Foreign-Invested VC Fund must be approved by MOFTEC and MST. Extensive documentation must be supplied to those authorities that demonstrates the parties' compliance with the eligibility requirements contained in the Rules. One disclosure item which may be particularly unexpected for experienced offshore venture capital fund sponsors and investors is that each investor is obligated to submit its most recent annual balance sheets and annual income statements, audited by an accounting firm. Another aspect of the Rules that will be wholly unfamiliar to offshore venture capital fund sponsors is that Foreign-Invested VC Funds are required to file with
MOFTEC a semi-annual report on their investment activities and as-yet unspecified operational information. In addition, the Rules indicate that certain governmental authorities will conduct annual inspections of each fund. This level of scrutiny may be unattractive to investors that are accustomed to higher levels of confidentiality that are typical in offshore funds. The Rules follow the FIE Laws by providing that 15% of the total committed capital of the Foreign-Invested VC Fund must be paid within three months from the date of the issuance of the fund's business license, with the remainder payable within three years of such issuance. This is more restrictive than is usually found in typical offshore venture capital funds, which often provide for an initial contribution and then subsequent periodic drawdowns of committed capital over the first few years of the fund's life (usually a fixed period) as investment opportunities arise. After the expiration of this period, investors would typically not be required to contribute any remaining undrawn portion of their committed capital. The Rules also place some additional limitations on Foreign-Invested VC Fund investments, including a requirement that all investments be in new and high-tech industries. Investments in listed securities and in investment real estate are prohibited. Moreover, a number of pre-existing restrictions remain on portfolio investments that will, to varying degrees, hinder venture capital investment in China, including the following: 1. a Foreign-Invested VC Fund may not invest in industries where foreign investment is prohibited by the government; 2. a Foreign-Invested VC Fund cannot borrow money, so it is effectively precluded from engaging in any form of leveraging; and 3. a Foreign-Invested VC Fund's investment in a portfolio company, combined with the joint investment of any other foreign investors, must represent at least 25% of the portfolio company's registered capital. The Rules also do not change existing foreign exchange controls, which make it difficult to repatriate foreign exchange capital contributions prior to the termination of a Foreign-Invested VC Fund. Further, the Rules contain provisions that generally prohibit any withdrawal of capital by the lead foreign investor during the life of the fund. However, the fact that Foreign-Invested VC Funds can have a relatively short life-span mitigates this problem to some extent. Conclusion Despite the limitations inherent in trying to reconcile existing Chinese law with customary offshore venture capital fund practice through supplemental rule-making, the enactment of the Rules evidences a strong desire on the part of the Chinese government to foster venture capital investment in China and to draw experienced venture capitalists into the domestic market. Yet, by limiting the Foreign-Invested VC Funds to well-established offshore and Chinese players and subjecting such funds to the bulk of the FIE Laws, the Rules appear to be only an initial step in this process which will not unilaterally spur the formation of a large venture capital industry in China. On the other hand, the opportunity for large international venture capitalists to team up with strategic partners in China to tap China's potentially large domestic capital market is a significant inducement to enter China via Foreign-Invested VC Funds. Entry by a few large fund sponsors could have a significant effect. First, foreign professional fund managers could begin training the initial group of Chinese fund professionals, who would in turn train other fund professionals. Second, if the funds are well-run and deemed to be a success by the Chinese authorities, further liberalization of the venture capital fund industry could occur. A number of fundamental questions, however, are left unanswered by the Rules. For example, no guidance has been given by the relevant Chinese tax authorities with respect to any unique tax issues arising from the operations of a Foreign- Invested VC Fund. Another issue that remains unclear is whether the Rules preempt similar regulations which have been
adopted by local governments, such as those in Shenzhen and Xiamen. Finally, it remains to be seen how the relationship of the various ministries in overseeing the Rules will develop. It appears that MOFTEC will be the principle ministry in charge of implementing the Rules, but the Rules also state that they shall be interpreted by MOFTEC, MST and SAIC. If these ministries interpret the Rules in an inconsistent manner, the positive impact of the Rules could be compromised. [1] A legal person is an organization that has capacity for civil rights and capacity for civil conduct and independently enjoys civil rights and assumes civil obligations in accordance with law, as defined under the General Principles of Civil Law. The Sino-Foreign Cooperative Joint Venture Law provides that a Sino-foreign cooperative joint venture can have either legal person status or non-legal person status. Traditionally, one of the major drawbacks of maintaining non-legal person status is that the partners of such entity do not enjoy limited liability. As discussed in this article, however, the Rules specifically state that, by agreement of the parties, one investor in a fund with non-legal person status can bear all the liabilities of the fund with the other investors liable only to the extent of their investment. This article originally appeared in the International Financial Law Review and is reproduced with the permission of the publisher.