New Regulation on Round-trip Investment - Circular 37 (Part II)

III. Circular 37’s Impact on the Offshore Private Placement and IPO
Given Circular 75 brought the round-trip investment into the foreign exchange regulatory system, it is one of the most controversial subjects in private enterprises’ offshore private placement and IPO since its promulgation in 2005. Unfortunately, certain provisions of Circular 75 are vague and as a result there are different understandings and criteria among local SAFE. To some extent, the Circular 75 becomes the primary obstacle to private enterprises’ entrance into offshore capital market, increasing the compliance costs of enterprises involved and adversely encouraging various “cross the wall” attempts. The limited legislative efficiency of Circular 75 has always been criticized by the industry. Circular 37 is published in such settings that its effectiveness and implementation will have significant implications on the private enterprises’ offshore financing and red-chip IPO.
1. Registration Is More Convenient
Circular 37 simplifies the registration requirement (e.g. only the first level SPV controlled by domestic resident is required to be registered; letter of intent for the financing executed with investor is no longer required; SAFE will not review whether the round-trip investment is subject to the approval of other regulatory authority, etc.), and in the attached procedural guideline, Circular 37 also provides clarity and more concise requirements on the latitude of review by the SAFE. These changes will limit the discretionary power of local SAFE, and uniform administrative practice of SAFE at different locations, so as to make the time and result of foreign exchange registration more predictable.
2. More Difficult to “Cross the Wall”
With the expansion of the range of definition such as “Special Purpose Vehicle”, “Round-trip Investment”, and the arrangement such as the foreign exchange registration for the ESOP implemented by the SPV at the pre-IPO stage, Circular 37 put the current prevailing practice for the purpose of circumventing the Circular 75 registration (i.e., establishment of offshore trust, doing a limit explanation of “equity financing”, etc.) under the regulation of SAFE. Pursuant to Circular 37, the round-trip investment by domestic resident through its owned or controlled SPV for investment of financing purpose is subject to the foreign exchange registration requirement; the exercise of the rights under the ESOP by the officers and employees of a pre-listing SPV is also subject to the completion of round-trip investment foreign exchange. With the implementation of these measures, the room for operation in such “grey area” will be substantially reduced.
3. Increased Punishment for Violation of Regulation
According to Circular 37, if a domestic resident has already made capital contribution to the SPV with his legally owned onshore or offshore assets or interest prior to the promulgation of Circular 37, but failed to complete the foreign exchange registration, the domestic resident shall provide the SAFE with an explanation. SAFE will make the supplementary registration based on the principle of legality and reasonableness. In the event the domestic resident violates the foreign exchange regulations, SAFE may also impose administrative sanction on the violator in accordance with the applicable laws. Such “Sanction first, Registration Later” principle is not the innovation of Circular 37. The same principle has been provided in the various implementation rules of SAFE after the promulgation of Circular 75.
Article 15 of Circular 37 uses a whole paragraph to list the detailed sanctions to be imposed under the Foreign Exchange Administrative Regulation on non-compliant activities. Pursuant to the legislative intent as embodied Circular 37 “relaxing the pre-registration review, and strengthen post-registration supervision”, if the domestic resident still fails to complete the round-trip investment foreign exchange registration in accordance with the requirement of Circular 37 after the relaxed conditions for the registration, the likelihood and scale of the administrative punishment may be greatly increased.
It should be particularly noted that in defining the “round-trip investment”, Circular 75 clearly covered the “contractual control”. However, the local counterparts of SAFE used different “rulers” when taking applications from domestic residents for foreign exchange registration regarding offshore financing. Particularly, in terms of whether the applicant should faithfully and completely disclose the VIE structure, the practice of local SAFE varies. The terminology of “obtaining ownership, controlling right, operation and management right and other rights and interests” adopted by Circular 37 does not cover “contractual control”. In this regard, in the future, when applying for foreign exchange registration, whether a VIE arrangement shall be fully disclosed and whether the registration can be accepted are yet to be tested. Circular 37 does not repeal the Regulation on the Merger and Acquisition of Domestic Enterprise by Foreign Investor jointly promulgated by six authorities including the Ministry of Commerce (“MOFCOM”) in 2006 (“M&A Rules”). M&A Rules requires “domestic company, enterprise or natural person that intends to acquire its related domestic company with the duly established or controlled offshore company shall obtain the approval from MOFCOM”. However, as during the past eight years, the MOFCOM rarely approves the application for such “related acquisition”. Therefore, M&A Rules has become an insurmountable barrier for the company that intends to conduct offshore financing with an offshore SPV through “related acquisition”. The direct establishment or indirectly control of a “SPV” offshore with the legally owned assets or equity either onshore or offshore by domestic resident (including the domestic institution and individual) is a part of the “related acquisition”. If the restriction under M&A Rules still remains unchanged, the enterprise that intends to conduct offshore financing will not be actually benefited by the registration as contemplated under the Circular 37. Therefore, whether there is any implementation rule to Circular 37 to cure the defect and make up the loop holes, or whether SAFE has reached consensus with MOFCOM on the aforesaid “related acquisition”, or the promulgation of Circular 37 means the approval and practice by MOFCOM in connection with the “related acquisition” are issues worthy of attention.