On 19 December 2020 the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC) jointly promulgated the Measures of Security Review for Foreign Investment (Measures), which will take effect on 18 January 2021.

China's regulation on national security review of foreign investment can be tracked back to 2011, at which time the State Council and MOFCOM each issued their own policy documentation (2011 Rules) to initially build up a security review system for mergers and acquisitions of Chinese domestic enterprises by foreign investors. In 2015, the State Council issued further security review rules specifically apply in free trade zones of China (2015 Rules).

Opening Chinese market and facilitating foreign investments have been the theme of China's foreign investment over the years. For instance, Chinese regulators have taken steps to gradually reduce sectors and industries not allowed for foreign investments and remove shareholding limitations of foreign investors in certain industries. However, in response to fast-changing global situations, China's National Security Law and Foreign Investment Law have at a high-level called for an aligned national security review regime for foreign investments. In this context, the Measures are promulgated, on the basis of the 2011 Rules and the 2015 Rules, to further address national security concerns that might be triggered by foreign investments into certain sensitive or critical sectors.

Notifiable foreign investment activities

According to the broad language of the Measures, national security review may potentially be interpreted to apply to any foreign investments that have or might have national security impact on China.

What is considered a foreign investment?

Foreign investments, in the context of the Measures, include any of the following investments directly or indirectly made by foreign investors in China:

1. Greenfield investments by foreign investors or jointly with other investors in the form of establishment of new projects or enterprises in China.
2. Mergers and acquisitions by foreign investors of Chinese domestic companies, through which they acquire the equity interest in or assets of the Chinese company.
3. Other forms of investments made by foreign investors in China, which, by referencing to the 2015 Rules, may include contractual control, proxy holdings, trusts, reinvestments, overseas transactions, leases, and subscription of convertible bonds.

Despite that investments made by investors in Hong Kong, Macau, and Taiwan can usually benefit from certain preferential treatments pursuant to specific bilateral economic partnership/cooperation frameworks, this time, it is not the case. The Measures make clear that national security review regime provided thereunder applies to Hong Kong, Macau, and Taiwan investors as well, to the extent their investment activities may affect mainland China's national security.

What foreign investments are notifiable for a national security review?

The Measures set forth a very broad range of sectors and industries in which foreign investment would be subject to a prior national security review, these including:

1. Category A investments – military-related investments: military-related areas that have long been deemed highly sensitive, including (a) foreign investments in sectors concerning the security of national defense, such as military and military supporting industries; and (b) foreign investments in areas surrounding military installations and facilities.
2. Category B investments – investments in other key sectors: other key sectors that concern national security (to the extent that such investments lead to the acquisition of actual control over the target enterprises), such as key agricultural products, key energy and resources, manufacturing of key equipment, key infrastructure, key transport services, key cultural products and services, key information technology and internet products and services, key financial services, and key technologies.

As you can see above, Category A investments will automatically trigger a national security review, without any materiality threshold requirement. Yet Category B investments prompt to a national security review only when foreign investors obtain actual control over the target enterprises after the transaction. A control would be deemed acquired in any of the following situations:

1. Foreign investors hold 50 percent or more of the equity interest in the target enterprise.
2. Foreign investors hold less than 50 percent of the company's equity, but their voting rights significantly affect the resolutions of the board of directors, the shareholders meeting, or the shareholders meeting of the target enterprise.
3. Other circumstances in which foreign investors are able to exert a significant influence on the business decisions, human resources, finance, and technology of the target enterprise.

An obvious pitfall is that the Measures (perhaps intentionally) do not define "national security" or provide clarity on the exact scope of foreign investments covered by the national security review. For instance, what is the exact size of those buffer zones around military installations and facilities that are not allowed for foreign investments? What are the parameters to be considered when grading the "key-ness" of the investment target? Such unclarity may pose many problems and impose significant costs engaging in foreign investment activities in China.

Are public transactions also captured by the Measures?

No, foreign investors' acquisition of stakes in Chinese public companies through stock exchanges is explicitly excluded from the applicability of the Measures, but it does not mean such foreign investment activities will be left unregulated. On the contrary, Chinese regulators would be formulating separate rules that specifically apply to the investment in a public company by foreign investors.

Procedural requirements for national security reviews

Who is conducting the national security review?

The Office for Foreign Investment Security Review Working Mechanism (Working Mechanism Office), which is jointly established by the NDRC and MOFCOM and functions as an internal department within the NDRC, will be responsible for receiving and reviewing national security review applications and making final decisions. In addition, the Working Mechanism Office is open to cast light on any questions or concerns relevant parties may have before making foreign investments.

The Measures imply that the Working Mechanism Office may designate provincial level governmental agencies to receive application materials from the applicants and forward the same to the Working Mechanism Office. That means, in lieu of direct submission of application to the Working Mechanism Office, applications may also be submitted to local governmental agencies for further handling. However, the Measures are silent on whether the local governmental agencies will be granted any authority to conduct an initial review. If not, it seems practically meaningless for the applicants to submit applications to local agencies which may drag on the review process if there are delays in forwarding documents.

Who is responsible for making an application?

Foreign investors or their Chinese counterparts are responsible for filing a national security review application with the Working Mechanism Office. In addition to voluntary applications made by parties concerned, the Working Mechanism Office may take initiative to instruct parties concerned to file their case, if the parties do not do so on its own.

The Working Mechanism Office also welcomes whistleblowing. Any third parties, such as governmental agencies, enterprises, public organizations, and individuals, may voice their opinions and suggestions to the Working Mechanism Office if they believe a given foreign investment transaction will or may give rise to national security concern. The Measures do not set forth a specific timeframe for whistleblowing, which implies that it can be made anytime, even after a particular foreign investment is completed. And consequently, it is possible that the Working Mechanism Office may initiate a national security review at any stage of foreign investment activities.

What are the procedures and timeline for a national security review?

We have prepared a chart below to briefly lay out the procedures and timeline for a national security review.

As shown in the above chart, in normal situations, a national security would take less than 45 working days if the Working Mechanism Office concluded that no national security concern exists. These include 15 working days for the Working Mechanism Office to conduct a preliminary review to decide whether a national security review is needed. If indeed needed, the Working Mechanism Office will proceed to a "standard review" phase which will last at a maximum of 30 working days, to evaluate whether the proposed foreign investment has or might have impact on China's national security. If it is concluded that the proposed foreign investment will or might give rise to national security concerns, the case will enter the "special review" phase which can take up to 60 working days, and even be followed by an "extended review" which lasts for an indefinite period. Foreign investment plan can be amended or withdrawn at any time during the review. In the case of amendment, the procedures, and time periods as specified above will be recounted.

A notable issue here is the Measures are silent on the circumstances and criteria to be taken into account when deciding whether a case needs to enter into the phases of "standard review", "special review", and even "extended review." It will therefore be difficult for investors to forecast a reasonable timeline to complete the review process.

Results of national security review: conditional clearance as the third option

In addition to a yes-no decision concluded based on the evaluation of the impact on national security, the Measures follow the footsteps of the 2015 Rules: building in a "conditional clearance" mechanism to allow regulatory agency to consider a trade-off between prohibiting a proposed investment and granting a conditional clearance. 

Below please find a chart which briefly describes decision-making mechanism of the Working Mechanism Office.

As you can see, a case clearance will be granted if the Working Mechanism Office concluded that the proposed foreign investment plan does not have impact on China's national security. In the opposite case, a prohibition of making such foreign investment could be granted. As a third option, for the cases that are concluded to entail national security impacts, the Working Mechanism Office may impose conditions to its clearance, if such impacts can be eliminated through the imposition of remedies.

Still, great ambiguity occurs when one tries to figure out what aspects will the Working Mechanism Office examine in its reviewing, what standards and factors will be considered, and what circumstances or situations will lead to a conclusion of no national security impact or eliminable national security impacts? Again, such opacity will be a barrier for foreign investors to reasonably anticipate a potential review result, and hence properly structure their investment plan from the very beginning.

Consequences for noncompliance

The Measures, for the first times, set forth legal consequences for noncompliance with China's national security review regime established therein. That is also a sign of Chinese government's determination to push ahead the security review on foreign investments. Specifically, the Working Mechanism Office may order the foreign investors (and Chinese counterparts, as applicable) to dispose equity or assets, or take other necessary measures within a specified timeline so as to restore to the state before the making of foreign investment and eliminate national security impacts, if the parties concerned fail to obtain a clearance or make the investments in accordance with conditions imposed, or provide false information or conceal facts. In addition, the parties concerned might be recorded in China's national credit system.

Outstanding issues

Although the Measures provide more comprehensive provisions on foreign investment security review compared to the 2011 Rules and the 2015 Rules, there still exist quite some issues that require further clarification. Most importantly:

• It remains a question how the national security review regime under the Measures will be coordinated with other existing review and approval mechanisms and regulatory schemes. For instance, currently MOFCOM already has in place review requirements for foreign investments in sensitive sectors; additionally, the NDRC has also set forth a prior review requirement for fix-asset investment projects. It is unclear how these multiple review and approval systems, which more or less evaluate national security concerns already, can coordinate or connect with each other to avoid repetition of administrative work. Furthermore, the long-waited Provisions on the Unreliable Entity List issued by MOFCOM provide for a mechanism to identify any foreign enterprise, organization, or citizen found to have done something that endanger the national sovereignty, security, or development interest of China as an unreliable entity, as a result of which, making investment in China may be prohibited or restricted. We will need to see how MOFCOM, NDRC, and the Working Mechanism Office come up with an effective process to coordinate all these regulatory efforts.
• The Measures fail to touch the essence of many substantive aspects in a national security review. For instance, as we have commented above, the Measures do not set forth main factors the Working Mechanism Office consider when deciding whether a foreign investment case should be subject to national security reviews or additional phases of reviews. And neither does it specify any criteria for concluding a clearance, conditional clearance, or prohibition decision. These are the most valuable information for foreign investors to preliminarily evaluate whether a national security review might be triggered and anticipate potential review results.

These open issues will not only increase Chinese regulators' work load and time of case reviewing, cause uncertainty, and delay transactions, but may also allow regulators to reject transactions for seemingly political reasons. Therefore, we expect the supporting rule will be issued at a later stage to cast insight on more detailed implementation requirements to provide more clarity to dealmakers. However, even if detailed guidance becomes available, it is unlikely that ambiguity can be entirely solved, so that the Working Mechanism Office can still retain a relatively wide discretion in decision-making. We recommend dealmakers always conduct a prior national security review analysis to assess the risk of being caught by the Measures and even consider approaching the Working Mechanism Office for official guidance if the transaction is in particular controversy.

Authored by Roy Zou, Lu Zhou, Lan Xu, and Carol Shao.