Legal and Practical Analysis of Wholly Foreign Owned Enterprises (“WFOE”) Commencing Private Securities Investment Fund Management Business in the People’s Republic of China
On 30 June 2016, Asset Management Association of China (“AMAC”) released the FAQs regarding Registration and Record-Filing of Private Funds (No. 10) (“FAQ No.10”) under the permission of the China Securities Regulatory Commission (“CSRC”). FAQ No. 10 confirms that foreign financial institutions may engage in private securities investment fund management business by establishing wholly foreign owned enterprise (“WFOE”) in the People’s Republic of China (“China” or “PRC”) and also sheds light on issues regarding the procedures of private securities fund manager registration. The release of FAQ No. 10 is the most determined gesture made by the Chinese regulator to further open up its funds market ever since 2002, when China allowed foreign financial institutions to set up joint venture companies to carry out publicly offered securities investment fund management business.
This article integrates the background information of the release of FAQ No. 10 with its content and introduces, in a practical approach, the conditions of establishing WFOE and engaging in private securities fund management business in China and the requirements of applying to register as a private securities fund manager in the hope of providing assistance to foreign financial institutions that are planning to establish WFOE and engage in private securities fund management business in China.
I. FAQ No. 10 as an important step realizing China’s commitment to open up its funds market
Prior to the release of FAQ No. 10, the maximum foreign shareholding ratio of a publicly offered securities investment fund manager or a private securities investment fund manager had been 49% according to the Catalogue of Industries for Guiding Foreign Investment (2015 Revision).
On the other hand, there had been no restriction on the proportion of foreign investment in non-securities private fund managers, such as private equity fund manager and venture capital fund manager, etc. Namely, foreign ownership in these managers could reach 100%.
In order to further open-up the Chinese funds industry and facilitate market competition, the Chinese government has made a series of commitments regarding the opening-up of the Chinese market since 2015:
- The Seventh China-U.S. Strategic and Economic Dialogue (2015.6.23)
The PRC government committed to increase participation of foreign financial services firms and investors in the PRC capital market, for which policies include allowing qualified WFOE or joint venture private fund management institutions to establish private securities fund management business in China that includes secondary market securities transactions according to regulations. - The Seventh China-UK Economic and Financial Dialogue (2015.9.21)
Both the Chinese and British governments realized the great opportunities in the cross-national cooperation of asset management and agreed to further facilitate the investment and capital flow in the markets of the two nations. For this, the Chinese government agreed to allow qualified WFOE or joint venture private fund management institutions to commence private fund management business, including secondary market securities transactions, in China provided that all relevant PRC regulations were complied with. - The Eighth China-U.S. Strategic and Economic Dialogue (2016.6.6)
Following its 2015 S&ED commitment, China is soon to issue regulatory and qualification requirements to allow wholly foreign owned firms to engage in private securities fund management.
FAQ No. 10 implements the above policy achievements. It is a concrete measure and an important step to fulfill China’s commitment to open-up its funds industry. After the release of FAQ No.10, a qualified WFOE may engage in private securities investment fund management business in China.
II. The business scope of a WFOE as a private securities investment fund manager and the regulations thereof
Alike with a domestic private securities investment fund manager, a WFOE registered with AMAC may engage in private securities investment fund management business in China. According to the Law of the People’s Republic of China on Securities Investment Law, other laws and regulations and the self-disciplinary rules of AMAC, the major regulations on aspects such as fundraising and investment operations of the private securities investment fund management business are as follows: - Legal relationship: Trust
The manager and the custodian join as the co-trustees of the private securities investment fund.
The most common legal form of a private securities investment fund is a trust. The WFOE as the private fund manager, the custodian and the investors form a legal trust, and the manager and the custodian are the co-trustees of the private fund. - Fundraising method: Non-public
The fundraising and management of the private securities investment fund shall be carried out in China. The fundraising method shall be conducted on a non-public basis. Publicity and promotion to non-specified targets through newspaper, periodicals, radio, television, the internet and other public media, or by way of lectures, seminars or analysis forums, etc. are prohibited. - Fundraising targets: Shall not exceed 200 qualified investors
An investor of a private securities investment fund shall be a qualified investor and the number of qualified investors investing in the fund shall not exceed 200 in case of a contractual private fund. Qualified investors include:
(a) A qualified institutional investor: an institution with net asset of RMB 10 million or above;
(b) A qualified individual investor: an individual with financial assets worth RMB 3,000,000 or above or an individual with an average annual income of RMB 500,000 or above in the recent three (3) years. - Investment scope of the fund
A private securities investment fund can invest in securities issued in China, including stocks of companies limited by shares issued publicly in China, bonds, fund units and other securities and derivatives thereof recognized by the CSRC. A private securities investment fund shall not invest in securities issued outside China except for sale and purchase of specified foreign stocks through stock connect programs such as the Shanghai-Hong Kong Stock Connect program and QDII qualification and quota issued by regulatory authorities to private fund managers in future. - The possibility of applying for publicly offered fund management business qualification
Pursuant to Article 96 of the Law of the People's Republic of China on Securities Investment Funds, a fund manager specialized in non-publicly-raised fund management business, if satisfies the conditions regulating its shareholders, senior management personnel, business period, fund assets under the management, etc., may carry out publicly offered fund management business under the approval of the CSRC. Despite the current restrictions imposed on publicly offered securities investment fund management companies limiting foreign investment proportion to a maximum ratio of 49%, there is in fact a possibility that, in future, a WFOE which satisfies specified conditions will be allowed to carry out publicly offered fund management business under approval in view of the increased level of opening-up of the PRC market.
III. The qualification requirements to be satisfied by a WFOE in order to engage in private securities fund management business
The most concerned question of foreign investment institutions is what conditions a WFOE has to satisfy in order to engage in private securities fund management business in China. On the whole, the qualification requirements are largely divided into two different parts: the first part consists of special requirements to be satisfied by a WFOE, as known as “Special Requirements”; the other part consists of conditions that all domestic and foreign private fund management institutions engaging in private fund raising business in China have to satisfy, as known as “Common Requirements”. The two large parts of the qualification requirements are discussed in below. - Special Requirements
According to FAQ No. 10, a WFOE that satisfies the conditions below may engage in private securities investment fund management business in China:
(a) The WFOE shall be a company incorporated in China
The WFOE established by the foreign institution shall be a company incorporated in China, instead of operating as a partnership enterprise. Although two or above foreign enterprises may establish partnership WFOEs in China according to Article 2 of the Provisions on the Registration of Foreign Invested Partnership Enterprises, as limited by the requirements in FAQ No. 10, a WFOE that carries out private fund management business shall only be incorporated as a limited liability company.
(b) The securities regulatory authority of the country or region where the shareholder of a WFOE domiciles shall have entered into the Memorandum of Understanding for Securities Regulatory Cooperation (“MOU”) with the CSRC or other institutions recognized by the CSRC
Up till June 2016, the CSRC has entered into the MOU with the securities regulatory authorities of the following countries or regions:
Hong Kong, the United States, Singapore, Australia, the United Kingdom, Japan, Malaysia, Brazil, France, Germany, Italy, Egypt, Korea, Romania, South Africa, the Netherlands, Belgium, Canada, Switzerland, Indonesia, New Zealand, Portugal, Nigeria, Vietnam, India, Argentina, Jordan, Norway, Turkey, United Arab Emirates, Thailand, Liechtenstein, Mongolia, Russia, Dubai, Ireland, Austria, Spain, Taiwan, Malta, Kuwait, Pakistan, Israel, Qatar, Laos, Sweden, Luxembourg, Cyprus, Ukraine, Lithuania, Guernsey, Belarus, Brunei, Jersey, Isle of Man, Poland, Kazakhstan, Azerbaijan.
In practice, we have observed that many foreign financial institutions wish to use companies set up in jurisdictions where there are tax advantages, such as Cayman Islands, Virgin Islands and Bermuda, as the shareholder of the WFOEs for various reasons. Nevertheless, as the securities regulatory authorities of those countries or regions have not entered into the MOU with the CSRC, those companies do not satisfy the requirements of a WFOE’s shareholder in FAQ No. 10.
(c) The foreign shareholder of the WFOE shall be a financial institution duly approved or licensed by the financial regulator of the country or region where it domiciles
FAQ No. 10 does not only realize the Chinese government’s commitments to the U.S. and the UK, but also allows a WFOE incorporated in China with a foreign shareholder established in other country or region that has entered into the MOU with the CSRC to apply to become a private securities investment fund manager. However, the foreign shareholder of the WFOE has to be a licensed financial institution. A non-licensed institution, such as a holding company of the other types, an SPV, etc., shall not be qualified as a foreign shareholder of the WFOE.
Regarding the requirements in FAQ No. 10, although the business to be carried out by a WFOE is fund management business, it is not necessary for the WFOE’s shareholder to have an asset management license. An institution with banking license, securities trading license, securities consulting license and other financial licenses will satisfy the industry category requirement for a foreign shareholder of a WFOE.
(d) Neither the WFOE itself nor its foreign shareholder has been imposed with any material punishment by any regulatory authority or judicial authority in the preceding three (3) years
This is a qualification requirement for both the WFOE and its shareholder. In practice, different regulatory departments, administrative or self-disciplinary proceedings have different standards towards the meaning of “material punishment”. The “materialness” is not only manifested in the fines, but also in the nature, the degree of seriousness, the social impact, etc., of the action against the laws and regulations. All of these shall be taken into account in order to conduct a comprehensive evaluation on whether the punishment is “material” or not.
To ensure that the WFOE can successfully register as a private securities investment fund manager and engage in its business accordingly, our suggestion is that the foreign financial institution shall endeavor to choose a foreign shareholder which has not been imposed with any regulatory penalty in the preceding three (3) years.
(e) For a WFOE that has an actual controller outside China, such actual controller shall also fulfill the above-mentioned requirements (b), (c) and (d). Namely, the securities regulatory authority of the country or region where the foreign actual controller domiciles must have entered into the MOU with the CSRC and the foreign actual controller shall also be a licensed financial institution which has not been imposed with any material regulatory penalty in the preceding three (3) years
According to the Company Law of the People’s Republic of China, an actual controller refers to a natural person or a legal person or an entity that may control the corporate behavior of the WFOE despite the fact that it isn’t a direct shareholder of the WFOE. In view of the fact that, financial institutions’ controlling methods and arrangements with subsidiary companies may vary in different jurisdictions, to identify a foreign actual controller, not only the PRC laws and regulations shall be referred to, but relevant foreign laws and regulations and the actual circumstances of the control that the foreign institution exercises on the WFOE shall also be taken into full consideration.
The Explanation of the Private Fund Manager Registration and Information Update published by AMAC in 2015 states that, to identify the actual controller, one shall trace to the ultimate natural person, or state holding enterprise/collective enterprise, or a foreign institution regulated by foreign financial regulators. To consider whether or not a WFOE has a foreign actual controller and, if yes, the identity of the actual controller, we suggest that the abovementioned definition could be taken as a reference.