Legal & Regulatory: China: VC regulations

Investing in privately-owned companies in China is sometimes compared to hitting a moving target, not only because product and technological developments are so rapid, but the markets in which those growth companies are operating can become saturated with competitors in a matter of months.

If finding a suitable target company weren’t difficult enough in a country full of entrepreneurs waiting to secure as much of the hot money flowing in as they can, investors have to keep abreast of increasing levels of regulation issued by numerous government departments, which may or may not be directed at them but invariably have some degree of impact.

“Some regulators are sometimes in the habit of dreaming up things overnight, which is a good thing because in the past they didn’t do a thing. Generally, it’s a good thing for investors because they care,” says Joseph Tzeng, managing director Crystal Ventures in Cleveland, Ohio.

“It takes a lot of patience to be a foreign investor and that is more apparent than it was before,” he says.

Patience became a tested virtue last year for many foreign investors when the State Administration of Foreign Exchange (SAFE), China’s foreign exchange regulatory authority, issued Circulars 11 and 29, affecting deal flow because both announcements introduced regulatory uncertainty for venture capital investors.

“Under SAFE’s Circulars 11 and 29 you needed to get an approval from the Ministry of Commerce but there were no guidelines about the approvals: no-one knew what to do,” says Maurice Hoo, a partner in Paul Hastings’ China and Asia Private Equity Group, based in Hong Kong.

SAFE’s Circulars 11 and 29 were then superseded by SAFE’s Circular 75 which came into effect on November 1, 2005.

“It changed from an approval system to a registration system. Once the legal clarity was introduced, deals went forward,” says Hoo.

Constant Tang, executive director at Latitude Capital in Hong Kong, says he was working on a deal which stalled during the uncertainty of the issuance of those circulars by SAFE last year, but once Circular 75 was issued, its clarifying influence helped the deal progress.

SAFE’s Circular 75, or the Circular on Issues Relating to Financing through Offshore Special Purpose Vehicles by Domestic Residents and Round-Trip Investment, clarified the PRC’s overall attitude to offshore VC investments by setting out clearer registration procedures and expressly permitting VC transactions involving offshore SPV structures, subject to compliance with foreign exchange registration requirements.

Circulars 11 and 29 were largely issued to manage the growing trend of hui cheng or round-trip investing where PRC-based assets were moved to offshore holding companies by transferring those assets to a wholly foreign-owned enterprise (WFOE) that is held by an offshore SPV, usually a company incorporated in the Cayman Islands or British Virgin Islands.

Both circulars were widely regarded as a major roadblock to most VC transactions involving PRC domestic assets and residents. They added complications to VC and PE deals, many of which were put on hold for months.

Equity investments made by domestic residents, even those that did not include cash elements, had to seek approval from SAFE and the Ministry of Commerce. The circulars also limited the opportunity for Chinese companies to move their assets offshore, making them less attractive to investors.

The types of deals most hindered were those featuring exit options of an offshore listing by an offshore holding company and offshore sale.

Circular 75 retains the core element of the two earlier circulars, that is, SAFE’s authority to review the establishment or acquisition of offshore entities by PRC domestic residents or entities for the purpose of foreign exchange control and to prevent tax evasion and for other purposes.

How international VC investors benefit from Circular 75 is that it defines terms and simplifies procedures. Circular 75 gives detailed definitions for four principal terms: special purpose vehicle; round-trip investment; domestic residents and control.

A special purpose vehicle (SPV) is defined as an offshore entity directly established or indirectly controlled by PRC residents for the purpose of offshore equity financing (including convertible debt financing) using their domestic enterprise assets or interests.

A domestic resident can include both those PRC nationals (passport and ID card holders) and individuals who do not have such legal status in China but for economic reasons spend most of their time in the country.

A round-trip investment has been defined as one featuring direct investment activities made in China by residents through offshore SPVs. These include the purchase and swap of assets held by Chinese parties in domestic enterprises, setting up foreign-invested enterprises (FIEs) in China, controlling domestic assets through contract, or purchasing domestic assets and using the assets to establish FIEs or increase the registered capital of domestic enterprises.

Control is defined as PRC residents who obtain operating rights, rights to receive profits, and decision-making rights through trusts, nominee arrangements, voting rights, repurchases, convertible debt or similar methods.

There has yet to be any announcement about whether individuals with small non-controlling shares in companies will be exempt from the registration process.

According to Rocky Lee, head of the venture capital & private equity practice, China at DLA Piper in Beijing, this is an issue that needs to be addressed.

“I think the law may be changed such that there is a threshold, for example, where an employee owns less than a certain percentage of shares in the company there will be no need to report this,” he says.

Generally, the VC industry in China has welcomed the reaction by SAFE following many representations made to it by the Chinese Venture Capital Association (CVCA).

“The PE industry has worked very hard with the Government – the CVCA met SAFE many times – to find a resolution,” says Hoo. “The Chinese Government had an open mind about the issue. To supersede the previous notices [Circulars 11 and 29] within one year was remarkable.”

Regulatory burden?

Nevertheless, with the clarity comes a greater regulatory framework, which leads to more time-consuming red tape, according to some VCs.

Considering the bigger regulatory picture in place for foreign investors, it is not just in China where the red tape has lengthened. VCs setting up Cayman Island companies are subject to very detailed information disclosure requirements, which they have to comply with if they want to secure the relevant licence from the Chinese authorities.

“In the past, all the authorities wanted to know was that it was a wholly foreign-owned enterprise,” says Tzeng. “We are having to make additional filings to various authorities now. Everyone is trying to be nice and compliant to get the relevant licence.”

Tzeng says that of all of the legal framework that he comes across, 80% of it is regulation from the various ministries and administrative bodies in China.

“The changes mean that legitimate PE transactions can now once again proceed using Special Purpose Entities to structure deals offshore. Circular 75 does however place the onus on the seller with more reporting requirements,” says Matthew Phillips, a partner in transaction services at PricewaterhouseCoopers in Shanghai.

Before a PRC resident can set up an offshore SPV for raising offshore equity financing, six mandatory documents have to be filed with SAFE to register for foreign exchange controls in relation to the offshore investment.

In one document, the applicant has to declare information about the PRC company, details about the equity structure of the SPV and how the offshore financing will be raised and by whom.

Also, the PRC legal person, which is typically a company, has to provide two approval certificates concerning the source of foreign exchange capital (assets), and the proposed offshore investment. SAFE and the Ministry of Commerce each issue a certificate.

The SAFE Circular 75 is being broadly interpreted by the VC community as another step towards allowing PRC residents greater investment freedoms while keeping a track on foreign exchange – an issue that has always been very sensitive in the centrally-planned country.

However, in mid-April China’s central bank announced it will relax controls on foreign exchange accounts, simplifying approval procedures for foreign exchange payments in the service trade and procedures for individuals to buy foreign currencies.

Individuals will be allowed to take up to US$20,000 a year out of the country but it is not clear what the limits will be for companies.

Not everyone anticipated that Circular

75 would appear last year and some deals went ahead even though there was little guidance. SAFE has announced, however, that retrospective applications can be made, but there is the chance that some will not be registered.

“Some deals which were done with ‘creative structures’ after SAFE Circulars 11 and 29 in 2005 could have a task of cleaning up the structures,” says SC Mak, managing director at Walden International in Hong Kong.

“The offshore structure has proven to be viable for IPO/exit on an offshore stock exchange. SAFE Circular 75 lays out the procedure for such a structure,” says Mak.

“It works well with a company with a small asset base, such as those in the Internet

or wireless value added services industries, but could still present a hurdle for asset-heavy companies, because the Chinese legislation requires actual funds flow for acquisitions,” he explains. “The regulatory authorities have been drafting a regulation on cross-border shares swap, which might address this issue, but the regulation has not come out yet.”

“The VC and PE industry is now hopefully working with government departments to see how equity swaps can be done,” says Hoo. “The ability to do equity swaps will be a huge help to the amount of PE deals that can be done.”

However, some venture-backed companies may be facing problems with the existing legislation in trying to exit their investment. “There are new emerging concerns relating to Ministry of Commerce approvals,” says Lee.

China’s domestic venture capital market received a further boost late last year when the National Development Reform Committee (NDRC) issued the Provisional Measures on the Administration of Venture Capital Enterprises (Measure No. 39).

“On the surface, Measure No. 39 applies only to domestic venture funds and should have little direct impact on international venture investors. However, Measure No. 39 appears to encourage the formation of a domestic venture fund industry in China, which may ultimately level the playing field and alter the landscape of venture investments in China,” writes Maurice Hoo of Paul Hastings in a client briefing.

The PRC venture fund industry is still developing, however. The Chinese government first encouraged a domestic venture capital market in 2001 with its Tentative Rules on Forming Foreign-Invested Venture Capital Investment Enterprises and then the Regulation on the Administration of Foreign-Invested Venture Capital Enterprises in 2003, which encouraged foreign investors to form venture funds in China (Foreign Invested Funds). However, very few of these funds have been formed to date.

“Measure 39 is in no way detailed enough to be implemented because it relies so much on what the other government departments need to announce. However, it expresses an intention,” says Hoo.

The NDRC, in Measure No. 39, has encouraged other PRC government agencies to grant tax and regulatory preferences to venture funds that are organised in China and held only by PRC investors.

The capital contribution required for a Domestic Fund is RMB30m (US$3.74m), whereas the capital contribution required for a Foreign Invested Fund is US$5m.

The minimum investment amount for a single investor in a Domestic Fund is RMB1m, whereas the minimum investment amount for a single investor in a Foreign Invested Fund is US$1m. Foreign Invested Funds are subject to more stringent requirements than Domestic Funds concerning the qualification of investors.

A Foreign Invested Fund, for example, must have at least one investor that has at least US$100m under management during the three years prior to its investment in the Foreign Invested Fund.

Forming a Domestic Fund requires registration with State Administration of Industry and Commerce or its local office and then a filing with NDRC or a local government department authorised to receive such filings, whereas the formation of a Foreign Invested Fund requires the approval of the Ministry of Commerce.

Measure No. 39 encourages favourable treatment of Domestic Funds, including government financing through direct investments, loans or guarantee arrangements; favourable tax treatments for investments in specific industries such as high technology; and setting viable exit channels through the capital markets, share transfers or redemption of shares.

Although the NDRC is clearly trying to raise the profile of the domestic VC market, a number of questions remain unanswered about what role the Chinese funds could play. Would Domestic Funds be allowed to co-invest with Foreign Invested Funds or investors outside China? Would they be allowed to invest in PRC companies through an offshore holding structure?

“Together with the accumulation of privately-held capital in China looking for investment opportunities, and strong connections between the domestic venture capitalists and the founders, Domestic Funds could become a strong force in the venture industry in China, and alter the venture landscape currently dominated by investors organised outside China,” says Hoo.