China's national security review: motivations and the implications for investors.

Author:Hartge, Cathleen Hamel
 
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Foreign direct investment in China has been a bright spot in the midst of a global recession. The economic powerhouse attracted a record $244 billion in foreign direct investment in 2010, up more than eighty percent from the previous year's total of $131 billion. Over the past decade, twenty percent of foreign direct investment to developing countries has gone to China. While these investment dollars generate significant economic benefits, they have also aroused concerns among Chinese leaders that they pose a potential threat to China's national security.

Responding to these concerns, on February 3, 2011, China announced a formal process for reviewing mergers and acquisitions (M&A) of domestic companies by foreign investors for national security implications. Theories abound among commentators as to China's motivations in announcing a new national security review mechanism. Some analysts have expressed concern that China will use the review process to make it increasingly difficult for foreign investors, especially those from countries that have traditionally restricted Chinese investment in their own economies, to carry out M&A transactions in China. But this Note demonstrates, though historical analysis and a comparison of the U.S. and Chinese systems, that China merely seeks to clarify its investment regulations and that investors will benefit from this development. Although the Chinese system is far from perfect, it will at least systematize what has been, until now, an ad-hoc review process.

INTRODUCTION I. CHINA'S GRADUAL, INCREMENTAL DEVELOPMENT OF A NATIONAL SECURITY REVIEW SYSTEM A. The National Security Review Has Existed for Years, and Its Evolution Has Been Shaped by Genuine Economic Security Concerns 1. The Journey Towards a Formal National Security Review Begins: From the 2003 Interim Provisions Through the 2008 Anti Monopoly Law 2. China Takes the Final Step in 2011: From the State Council's Circular Six Through MOFCOM's Clarifying Regulations B. China's Past Responses to Prior Investments Show that Its Government Has Been Primarily Motivated by a Desire to Protect Its Economic and Security Interests C. As an Extension of Existing National Security Review Law, the New Rules and Regulations Will Bring Greater Predictability and Transparency to the System II. CHINA'S NATIONAL SECURITY REVIEW AND CFIUS: CUT FROM THE SAME CLOTH A. A Brief Introduction to CFIUS B. Comparison Between CFIUS and China's New Mechanism 1. Review Bodies 2. National Security Review Process 3. Sectors of Focus 4. Transactions Subject to Review: Covered Transactions and Foreign Control 5. Criteria for Evaluation 6. CFIUS in Practice--And What It May Tell Us About the Chinese System III. AMBIGUITIES OF CHINA'S NATIONAL SECURITY SYSTEM: IMPLICATIONS FOR INVESTORS, AND RECOMMENDATIONS TO IMPROVE THE LAW A. Additional Delays for Investors B. Uncertainty Regarding Retroactivity C. Complex Relationship with Existing Investment Regulations and Reviews D. Broad Definition of Industry Sectors and Transaction Types Triggering Review E. Anti-Circumvention Principles CONCLUSION APPENDIX A: CHINA'S NATIONAL SECURITY REVIEW PROCESS APPENDIX B: RESULTS OF CFIUS NOTIFICATIONS, 1988-2010 APPENDIX C: FLOWCHART ILLUSTRATING CFIUS REVIEW PROCESS INTRODUCTION

Foreign direct investment in China has been a bright spot in the midst of a global recession. The economic powerhouse attracted a record $244 billion in foreign direct investment in 2010, up more than eighty percent from the previous year's total of $131 billion. (1) Over the past decade, twenty percent of foreign direct investment to developing countries has gone to China. (2) While these investment dollars generate significant economic benefits, they have also aroused concerns among Chinese leaders that they pose a potential threat to China's national security.

Responding to these concerns, on February 3,2011, the General Office of the State Council, China's highest executive body, announced a formal process for reviewing mergers and acquisitions (M&A) of domestic companies by foreign investors for national security implications. (3) The announcement, commonly known as Circular Six, (4) was followed in March and August of 2011 by clarifying departmental rules released by China's Ministry of Commerce (MOFCOM). (5)

Theories abound among commentators as to China's motivations and timing in announcing a new national security review mechanism. What drove the State Council's decision--and why did it take action now? One commentator has pointed out the "hardly coincidental timing" that China's announcement of Circular Six came within days of when the United States' national security review body-the Committee on Foreign Investment in the United States (CFIUS)--advised Huawei, a major Chinese technology company, to divest assets it had recently acquired from a U.S. company due to potential negative implications for U.S. national security. (6) Indeed, China has seen many high-profile deals fail because of other countries' national security concerns regarding Chinese acquisitions of their domestic firms in strategic sectors. Although the new provisions were in the works long before CFIUS's Huawei announcement, some analysts have expressed concern that the timing of the announcement evinces China's retaliatory intent. (7)

As this Note will show, however, the history behind China's national security review mechanism indicates that it was primarily motivated by a desire to create a viable and transparent security review system to protect its economic security interests rather than to retaliate against other countries. Moreover, the announcement of a formal mechanism should hardly be a surprise to the investment community, given that earlier versions of a national security review have already made several appearances in Chinese legislation since 2003. (8) In Part I, this Note will explain why retaliatory motives are unlikely to be the driving force behind the evolution of China's national security review mechanism over the past decade. Instead, China was motivated by growing concerns about the absence of strong national and economic security policies to protect its interests.

The resemblance of China's national security review mechanism to that of its U.S. counterpart, CFIUS--which has been active for decades and is well known in the investment community--bolsters this Note's argument that China is motivated by a desire to build a sophisticated system that protects its security interests, not by retaliatory intent. To illustrate this point, Part II compares in detail the key features of the two systems. By adopting an already-functional system, and even opening up provisional rules to public comment, China has demonstrated its commitment to developing a workable process to strike the difficult balance between protecting security interests and encouraging investment.

Despite China's efforts to establish a functional system largely based on the CFIUS model, China's national security review mechanism, as analyzed in Part III, still has some remaining ambiguities and uncertainties due to vague provisions in the new rules. This part also discusses implications of these deficiencies for foreign investors. This Note concludes by offering recommendations to the Chinese government to improve and further clarify the law.

  1. CHINA'S GRADUAL, INCREMENTAL DEVELOPMENT OF A NATIONAL SECURITY REVIEW NYSTEM

    The history behind China's national security review for foreign M&A activity demonstrates that Circular Six was hardly a knee-jerk reaction to recent events. Indeed, China's rules and regulations in this area have been evolving for nearly a decade, and the latest announcement presents the most detailed explanation of the review process that the government has offered to date. If anything, the new rules and regulations should be understood as extensions of existing law, bringing transparency and clarity to the national security review process.

    Nonetheless, some critics have pointed out China's timing in announcing its new procedure. (9) The government issued Circular Six within days of CFIUS's recommendation to the prominent Chinese high-tech company Huawei that it voluntarily divest assets it recently acquired from U.S. tech company 3Leaf Systems; otherwise, President Obama would order Huawei to do so. (10) MOFCOM publicly criticized CFIUS afterward, emphasizing that "the acquisition of 3Leaf's technology assets is a normal business activity of Huawei ... and we regret" the decision. (11) A MOFCOM spokesman even went so far as to assert that "[i]t's clear that there are many cases where the U.S. is using a security review to refuse" Chinese investment. (12)

    Huawei's attempted acquisition of 3Leaf's assets is not an isolated example: China is no stranger to seeing its companies face political pressure from other governments as they try to acquire foreign companies. (13) Huawei, run by a former Chinese military officer, similarly failed to acquire U.S. company 3Com in 2008, after political pressure from Congress led the company to withdraw its CFIUS application. (14) China National Offshore Oil Corporation (CNOOC) also withdrew its bid for U.S. oil company Unocal Corporation in 2005 prior to CFIUS review due to political pressure. (15) One researcher has explained that "[t]here is an implicit American prohibition on Chinese participation in advanced technology. ... because the U.S. doesn't trust the Chinese government." (16) This rejection of Chinese investment occurs beyond the United States as well. (17) Indeed, one could easily develop a story that China was sending a signal to the United States in announcing its own analogue to CFIUS. Some commentators have thus interpreted China's national security review as a vengeful move directed towards western countries. (18) Under this line of reasoning, Chinese companies are continually obstructed in expanding their investment footprint abroad, (19) and the...

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