Opinion: How China’s National Security Review Would Apply to Foreign Investments in Financial Services
On Jan. 18, 2021, the Measures on Security Review of Foreign Investments (the "Security Review Measures"), jointly issued by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM), will be formally implemented.
According to the Security Review Measures, foreign investments that affect or are likely to affect national security will be subject to a national security review. A foreign investor who makes an investment in a target falling within one of the specified sectors is required to make an advance submission to the Office of the Foreign Investment Security Review Working Mechanism (Security Review Office), if such an investment would result in the foreign investor acquiring control over the target. The Security Review Office is part of the NDRC and is jointly led by the NDRC and the MOFCOM.
Depending on the investment’s impact on China's national security, the review may go through a three-stage process: initial review, general review and special review, which respectively takes 15 days, 30 days (which may not be extended, and does not include time for submitting supplementary materials) and 60 working days (which may be extended).
While there have been some references to national security review in respect to foreign investments in certain financial services under applicable regulatory rules, the Security Review Measures have, for the first time, introduced “important financial services” as one of the Sensitive Sectors. This means that foreign investments in targets falling within the scope of important financial services will be subject to submission to the Security Review Office for national security review.
This article highlights some of key implications of the Security Review Measures on foreign investments in the Chinese financial services industry and highlights key issues about their application.
Form of Foreign Investments
Unlike in the case of merger filing that applies to joint ventures and acquisitions, the establishment of wholly owned entities by foreign investors in “important financial services” would be subject to the Security Review Measures. This is particularly important for international financial institutions as many of them are currently setting up wholly owned financial institutions or converting their existing joint ventures into wholly owned entities in the wake of the new round of opening-up of the financial services sector to foreign investments. Variable interest entities (VIEs) are not commonly set up by international financial institutions, but some other international investors have adopted VIE arrangements for their investments in some financial institutions in China, so be aware that VIE arrangements are likely to fall within the definition of “foreign investments” under the Security Review Measures.
What qualifies as “important financial services”?
There is currently no definition of “important financial services” under the Security Review Measures, nor is there any guidance offered by relevant regulations. From our experience and our understanding of the techniques applied to legislating laws, regulations and rules of a similar nature, it is unlikely that a clear definition will be offered in the future, and even if more clarity is added, a catch-all clause would remain and would leave the authorities with wide discretion. This is largely consistent with the approach taken by other countries in this regard.
What is beyond doubt is that “important financial services” would not extend to all financial services and should more be related to financial services that may give rise to national security concerns. By reference to the focus of the China national security review in other areas ― which highlights the likely impact on national economic stability, social order, national defense security, and on the research and development capabilities of key technologies related to national security ― we believe that financial services or targets involving “financial infrastructure” (including the clearing system, payment system and credit system) or “systematically important financial institutions” as identified by the applicable financial regulators and/or China’s Financial Stability Committee would likely fall within the scope of “important financial services.” Foreign control of any of these types of institutions would likely face substantive challenges in passing the national security review.
In addition, if a foreign investment is in connection with a financial service that involves a significantly large number of retail clients or certain types of sensitive assets, such as pension funds, a national security review would likely be necessary, though the results may differ on a case-by-case basis.
By contrast, we tend to believe there is little risk that foreign control over financial institutions that offer general intermediary services or wholesale services primarily to institutional clients would be subject to national security review, considering the impact of such services would be limited on the general public, or the country’s financial system or infrastructure.
National security review vs. regulatory approval
Foreign investments in financial services in China are generally subject to approvals from financial regulators. The Security Review Measures are silent on how the national security review process would interact with the regulatory approval process. In reference to the merger filing process, we believe that, in general, any national security review would proceed in parallel with the relevant regulatory approval process. However, where new financial institutions are concerned, which typically involve a two-stage regulatory approval process, this is likely to involve a case-by-case analysis, and more clarity from the applicable authorities in this regard would be required.
Technically speaking, as the investments that may fall within the Security Review Measures would only actually be made when the relevant entity is incorporated (which usually occurs after they receive the first-stage regulatory approval), any national security review, if required, would be conducted after the first-stage regulatory approval is completed and before the entity is incorporated. That said, from a foreign investor’s perspective, it would be desirable to secure completion of the national security review before the first-stage regulatory approval to remove any uncertainty before the investor incurs significant investment costs.
National security review and regulatory approvals are two independent processes, but they are also interrelated. In deciding whether to approve or disapprove an investment in a particular financial service, the Security Review Office should generally seek the views of the relevant financial regulators. At the same time, when a financial regulator is assessing an investment falling within its jurisdiction, it is likely to also (even informally) consider the potential impact of the investment on national security.
Therefore, where regulatory approval for an investment has been obtained before the conclusion of the national security review, we believe that investors may draw comfort from the result of such regulatory approval so far as the substantive aspects of the national security review are concerned, even though the process for obtaining separate national security review approval may still need to be gone through subject to separate analysis.
A foreign investment in an important financial service will be subject to national security review only if such investment results in foreign control over the target. The Security Review Measures have adopted an expansive definition of “control” to cover a foreign investor exerting “significant influence” over the target’s operations, human resources management, finance or technologies. This is similar to the broad definition of “control” under China’s antitrust rules (if not broader), and, pending further rules from regulators, may potentially include foreign investments that give international investors veto rights over certain operational matters of the target — an arrangement that is not uncommon in connection with international investments in Chinese financial institutions — although we also reckon that national security review does not introduce the concept of “joint control” as in the case of antitrust review.
Existing investments vs. new investments
The Security Review Measures do not have retrospective force and, therefore, do not apply to existing foreign investments in China’s financial services industry. It is not entirely clear whether the Security Review Measures would apply to the establishment of new financial institutions that have been granted first-stage regulatory approval pending incorporation of the invested entities or those in respect of which application for the first-stage regulatory approval has been submitted pending such approval. Depending on the nature of the services that the new entities are seeking to undertake, a consultation with the relevant authorities may be required.
Observations and tips
The Chinese government sees opening up the financial services industry to foreign investment as critical to reforming and therefore developing a mature financial market. We believe the Chinese government is likely to take a cautious approach when applying the rules of national security review ― at least in the near to medium term ― to put international investors at ease. In fact, this was also the message clearly passed by the relevant government authorities when the Security Review Measures were announced.
In addition, from a policy perspective, the Chinese government will fully appreciate the critical importance of consistency in its policies. We anticipate that, except in certain extreme cases, the government will be reluctant to reject, on the grounds of national security, investments in those sectors that have been fully opened to foreign investment, such as the establishment of commercial banks, securities companies and fund managers.
In this light, while we advise adopting a case-by-case analysis in respect to individual investments, taking into account such factors as the nature of the business, sensitivity of the industry/assets, and the number of retail investors involved in a proposed investment, we believe that national security review should not be a concern to most recent investments that international financial institutions have made in China’s financial services industry, which are concentrated in asset management/wealth management and traditional investment banking businesses.
Looking ahead, special attention should be given to investments in the following circumstances:
• Investments to control special-type institutions, in particular financial infrastructure-related institutions, such as clearing houses and personal credit information/data collectors
• Investments to control “systematically important financial institutions,” including systemically important banking institutions, securities institutions (including futures, funds), insurance institutions, and other institutions of systemic importance in the financial industry as identified by the Financial Stability Committee
• Investments that, using special technologies or service models, may have relatively large impact on the sound operation of the market, public interest or national security in terms of technology, data, and customer base, among others.
The authors are partners in the financial institutions group at the Fangda Partners, a law firm headquartered in Shanghai.
The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.
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