On 3 February 2011, the State Council, China’s cabinet, promulgated the Notice on the Establishment of the Security Review System in M&As of Domestic Enterprises by Foreign Investors (Guo Ban Fa  No. 6) (Rules), which will take effect 30 days after promulgation.
The Rules, which adopt the term “M&A Security Review”, provide for the review of a variety of transactions across a diverse and non-exhaustive list of sectors, which may be blocked due to their impact on production capacity, stability of the national economy, basic social life order, or the capacity of indigenous research and development of key technologies.
The Rules have been anticipated since the AML was passed in 2007 and give effect to the broad reference to the review of transactions on national security grounds contained in Article 31 of the AML.
However, the Rules raise more questions than they answer, as detailed below.
The Rules provide that investments in the following sectors are subject to review (while noting that these appear non-exhaustive and may therefore be considered as indicative only):
The Rules further provide that the potential for M&A Security Review is not limited by the form that the investment takes, with the following types of investments caught by the Rules:
A purely offshore transaction, particularly where no other Chinese regulatory approvals are required, would appear not to be caught by the Rules. However, that raises a question mark about the relationship between the M&A Security Review and merger control review under the AML, which may be required in the case of offshore transactions. Furthermore, the sectors referred to in the Rules do not align with the Foreign Investment Catalogue or the separate M&A Rules, which provide for separate foreign investment approval procedures (which may include the review of national economic security considerations). In any event, it is clear that there is now an additional regulatory approval process that foreign investors must consider at the time of entering into a transaction involving assets in China or shares in a Chinese company.
The Rules provide for an assessment to be made regarding whether an M&A transaction will impact:
The following diagram illustrates the procedure for M&A Security Review under the Rules, as well as the relevant time periods provided for review:
As illustrated by the diagram, the process incorporates two stages of review; an initial routine review, and a special review. Firstly, a routine examination (through written inquiries made of government departments) must be conducted by an Inter-Ministerial Committee to determine if the transaction will harm China’s national security. If the relevant departments consider that the transaction will not affect national security, then there will be no need for any further review. However, if concerns are raised a further special review will commence, which will involve preparation of a separate evaluation report.
Investors must also be aware that under the new regulations, Chinese government agencies, trade associations, competitors, suppliers and other related parties have the power to apply for a review of a foreign investment deal, which may delay proposed foreign investments.
Following its investigation (and liaison with State Council), if the Inter-Ministerial Committee considers that a transaction has impacted or may impact national security, the Committee shall request that the Ministry of Commerce (MOFCOM) coordinates with other relevant departments to terminate the transaction, or take such other measures as may be required to eliminate the impact of the transaction on China’s national security.
With the promulgation of the Rules, one of the remaining gaps in the implementation of the AML has been filled. However, rather than clarifying how transactions may be reviewed on national security grounds, the Rules instead may give rise to greater uncertainty for potential investors in view of the broad range of transactions and sectors that may be subject to review.
Firms looking to make acquisitions in China or acquire control of domestic companies, particularly in sensitive sectors, will need to consider carefully and plan for the potential for their transaction to be reviewed on national security grounds. In addition to assessing the likelihood that a proposed transaction will be contentious and subject to complaints (and therefore potentially subject to review), investors should implement a strategy for engaging with officials and be prepared to carve out any sensitive parts of the transaction (by way of divestments or otherwise). Investors should also provide for the potential for review in the transaction documentation (particularly as the Inter-Ministerial Committee may cause transactions to be unwound). Hopefully the Inter-Ministerial Committee will publish further guidelines clarifying how investors can ascertain whether their transaction is potentially subject to review, and how they may make submissions to the Committee in support of a particular transaction. Further regulations are also expected in relation to the review of transactions involving domestic financial institutions, which are not covered by the Rules.
There are many questions remaining in relation to how these Rules will be applied in practice, such as the role that different ministries (or local authorities) may have in the process, and whether the Rules will be used to unwind transactions that have already been completed. What is clear, however, is that, more than ever, investors need to formulate and implement a considered strategy for investing in China or risk being caught on the wrong side of China’s “new Great Wall”.