Introduction and Overview

As one of the world’s largest economies, China exemplifies rapid development, having transformed from an agrarian society into a global economic powerhouse and a leader in trade and foreign exchange reserves. China’s implementation of high-level trade and investment liberalisation, coupled with a more comprehensive approach to opening up and relaxing foreign investment restrictions, has significantly boosted global trade. Over the past decade, China’s robust economy has attracted substantial investment and projects from overseas.

Current Trends of FDI and FIEs in China

Following the disruptions caused by the COVID-19 pandemic, many foreign-invested enterprises (FIEs) and FDI have exited the Chinese market. China’s inbound FDI dropped 27.9% in the first four months of 2024 to CNY360.2 billion. In April, only CNY58.5 billion flowed into the Chinese economy. Moreover, the net outflow of CNY11.8 billion in the third quarter of 2023 marked a record low since 1998.

Kindle, a US multinational company, ceased operations and cloud download services in China in 2023, while Shell, a transnational oil corporation, has also announced their withdrawal from the Chinese market in 2024. Companies that once regarded China as a key production and manufacturing base are now withdrawing from China and seeking alternative markets. Many have shifted their supply chains, either through nearshoring to economies like India or reshoring back to their home countries.

The statistics reflect a consistent downward trend in FDI and the number of foreign businesses operating in China. However, it still mirrors the global decline in foreign investments observed in 2023. Despite these changes, the situation may not be as alarming as it seems – many high-tech enterprises remain reluctant to exit the Chinese market. Regions such as the Pearl River Delta Economic Zone, the Yangtze River Delta Economic Zone, and the Bohai Sea Economic Zone offer advanced supporting equipment, facilities, and a comprehensive industrial chain, making China an attractive location for these businesses.

Exit Mechanisms for FDI and FIEs

To achieve a high level of economic openness, China requires more transparent and standardised exit mechanisms for market participants. This would enhance the efficiency of market exits and resource allocation, thereby promoting high-quality economic development. There are several ways in which FIEs can exit the Chinese market, including:

• M&A of foreign investors;
• dissolution and liquidation of FIEs;
• compulsory liquidation and bankruptcy;
• joint venture shareholder disputes; and
• foreign investment policies and investment disputes.

M&A of foreign investors

One of the primary methods by which foreign investors exit the Chinese market is through M&As. This process involves FIEs transferring or selling their ownership stakes or assets of their Chinese operations to another entity. The transferee may be either a domestic company or another foreign company operating within China. When ownership is transferred to domestic companies, local firms can benefit, such as through established operations, market presence, and potentially valuable technology or intellectual property; selling ownership to foreign companies may, on the other hand, benefit those foreign companies if they wish to remain in the Chinese market.

The M&A process as an exit strategy allows for investors and company owners to realise the value of their investment and exit the business:

• In the preliminary stage, the company needs to be accurately valued, usually by hiring advisers.
• After potential buyers have been identified, the company will be marketed and presented to potential buyers with reference to the information memorandum.
• During the negotiation stage with potential buyers, NDA agreements must be signed, and due diligence should be conducted, followed by deal structuring.
• The transaction will, then, be finalised through the letter of intent and the signing of the share purchase agreement (SPA) or asset purchase agreement (APA), allowing the deal to subsequently be closed.

An illustrative case is Carrefour, whose holdings were acquired by the Chinese brand Suning, leading to the definitive closure of 24 stores in China. In 2023, however, Carrefour and Suning were locked in a legal battle over its stores in China, illustrating the issue of lingering post-acquisition disputes in using M&A as an exit strategy. This observation implies a potential gradual disengagement from the Chinese market owing to an unsatisfactory business environment, and legal disputes, potentially prompting other FIEs to consider exiting the market through various strategies.

Nevertheless, according to the China M&A 2022 review and 2023 outlook issued by PwC China, the overall domestic M&A market in 2022 fell to its lowest level since 2014, to USD486 billion, decreasing by 20% from 2021 levels. Although this phenomenon can be attributed to various factors and interpreted in multiple ways, it may suggest that in recent years, M&As may not have been a common or prevalent exit strategy for foreign companies seeking to withdraw from the Chinese market due to the complexity of the process and the inconvenience of potential legal disputes.

The implementation of such an exit strategy could lead to a temporary reduction in the stock of FDI, potentially exacerbating a concerning downward trend observed within China. Such developments may erode foreign investors’ confidence in the Chinese market, affecting both existing investments and prospective ventures, thereby impeding and decelerating positive economic activities in the region.

Moreover, M&As entail complex regulatory and compliance obligations, necessitating potential dispute resolution and the possibility of post-merger litigation arising from integration phase challenges.

However, successful M&A transactions help to signal a healthy investment climate, encouraging future FDI inflows, contributing to reviving the economy from a downturn and high FDI outflows. The M&A process is also, compared to dissolution and liquidation, a generally faster process and results in a higher value realisation, making it a preferred exit strategy.

Dissolution and liquidation of FIEs

There is also another way in which FIEs can proceed to exit the Chinese market: through corporate dissolution and liquidation, whether voluntary or compulsory. Voluntary liquidation refers to the termination and dissolution of a company, including all its businesses and operations. This process is initiated by the company’s board of directors and approved by its shareholders. Liquidation essentially involves the company selling off its assets and, at the same time, settling all its outstanding financial obligations, including paying off debts.

Once the decision to voluntary dissolve and liquidate has been approved by the board of directors, the relevant government authorities shall be informed. After this has taken place and the liquidation and dissolution request has been approved, the company must then seek preliminary approval from the Ministry of Commerce (MOFCOM) in accordance with the Chinese Company Law. Subsequently, the FIE prepares for liquidation by forming a liquidation committee and developing a corresponding plan. This is followed by complex legal and regulatory compliance regulations involving cross-border considerations. Then, liabilities shall be settled, and remaining assets distributed. The whole process does not involve a court as an impartial party and is only conducted by interested parties. Therefore, the principle of due process and legal procedures must be strictly adhered to. The legal principles for voluntary corporate dissolution and liquidation can be summarised into three basic principles:

• the principle of due process;
• the principle of efficient liquidation; and
• the principle of organic unification of fully protecting creditors’ interests and taking other interests into consideration

The requirements for dissolution and liquidation as an exit mechanism include:

• protecting the reasonable rights and interests of all parties, striking a balance between all employees, creditors, shareholders and other interested parties in terms of their rights and obligations;
• effectively preventing debt evasion, ensuring a steady and orderly exit of market players;
• focusing on the overall and long-term interests;
• improving the efficiency of the exit; and
• avoiding lose-lose situations arising from prolonged disputes over interests.

To ensure a smooth dissolution and liquidation process, such requirements should be strictly adhered to.

There are various reasons for companies to undergo a voluntary liquidation and dissolution. It may be due to unfavourable business and economic conditions, or their desire to transfer assets or operations to another company. This method therefore serves as a viable exit strategy, whereby FIEs can divest assets, settle liabilities, and withdraw from the Chinese market.

Some FIEs may prefer voluntary dissolution and liquidation over M&A as operations can be completely wound up instead of merely transferring ownership. The company seeking liquidation will also have more control over the process compared to the M&A process, where there is shared control during the negotiations stage. Hence, FIEs that seek to exit the market may thus turn to voluntary dissolution and liquidation whereby they dissolve the company so it can be wound-up and cease to exist as a legal entity.

The dissolution and liquidation of a FIE may have several knock-on effects on the Chinese economy and its legal services. First, it may cause some immediate economic disruptions – it may cause job losses and suppliers relying on the liquidated company may face supply chain disruptions. Additionally, it may also impact investor and stakeholder confidence – liquidation as an exit strategy may signal reduced confidence in market stability.

Compulsory liquidation and bankruptcy

Compulsory liquidation

A company may also undergo compulsory liquidation, typically in response to insolvency. This process necessitates winding up operations, settling debts, and distributing any remaining assets to shareholders, thereby resulting in the company’s withdrawal from the Chinese market. However, compulsory liquidation is generally regarded as one of the last resort exit strategies due to the significant financial and reputational damage it may inflict, as well as the legal and administrative complexities involved and the negative signals it sends to the market.

The procedure operates in a similar way to that of voluntary dissolution and liquidation, ultimately leading to the cessation of all business activities, the distribution of assets, and the formal dissolution and termination of the company’s legal existence. Although this is not the most preferred exit strategy for an FIE, it may be more suitable for companies that are insolvent with little to no prospect of recovery, as illustrated in the case of Evergrande, which had to go into liquidation in early 2024 due to indebtedness and insolvency. This demonstrates how a company may exit the Chinese market, which applies also to FIEs and FDIs alike.        

Bankruptcy liquidation

When a company fails to repay its outstanding debts, it may be compelled to file for bankruptcy, but this is generally also seen as a last resort exit strategy. This initiates a process aimed at an orderly dissolution of the company to satisfy creditor claims. In this case, the company’s assets are liquidated to repay creditors and discharge liabilities. Utilising bankruptcy as an exit strategy offers debt relief to financially distressed companies, facilitates an organised wind-down of operations, ultimately resulting in the company’s exit from the market. This structured approach ensures an equitable distribution of the company’s remaining assets among creditors and provides a legal framework for resolving insolvency.

Joint venture shareholder disputes

Recently, there has been a notable uptick in joint venture and shareholder disputes, a phenomenon that has garnered attention, particularly among FIEs considering exiting the Chinese market. These disputes often stem from a variety of factors, including differing objectives, operational disparities, financial disagreements, and compliance-related issues.

For FIEs operating in China, these disputes are of significant importance when evaluating market exit strategies. The complexity and potential duration of resolving such disputes can impact the efficiency and success of exit negotiations and procedures. Sino-foreign joint venture contracts in China are governed exclusively by Chinese law, and courts in China may refuse to recognise any litigation or arbitration results that have adopted non-Chinese governing laws. In this case, such disputes can be resolved by methods like litigation and arbitration, with arbitration usually the preferred method for foreign investors.

Joint venture disputes involving FIEs have detrimental impacts on the Chinese market as they may result in:

• firms seeking to exit the market;
• reputational damage, negatively affecting relationships with stakeholders and chances of future investments in the market;
• prolonged litigation, inevitably resulting in increased litigation costs, potentially reducing returns from investments; and
• a negative impact on market dynamics, especially resulting from high-profile joint venture disputes, deterring potential foreign investors and FIEs from entering the market.

Foreign investment policies and investment disputes

Foreign investment policies

China has issued a 24-point action plan, titled the “Action Plan to Solidly Promote High-Level Opening Up and Make Greater Efforts to Attract and Utilize Foreign Investment”, regarding its foreign investment policies to attract foreign investment and boost foreign capital amid a worrying downturn. Such policies are being introduced to remedy the downward trend in FDI and FIEs exiting the Chinese market. Foreign investment policies include expanding market access in the main industries, equalising participation of FIEs in government bids, and facilitating cross-border data flows. Furthermore, through higher incentives and legal protections, the Chinese government can ensure that foreign companies are not disadvantaged and enjoy the same level of protection as domestic companies.

Investment disputes

When investment disputes arise, foreign companies may use arbitration, mediation or litigation to resolve such disputes. FIEs may also seek compensation and legal resolution to facilitate their exit from the market.

Conclusion

The decline in FDI in the period between 2023-2024 has been substantiated by statistical evidence, as aforementioned, prompting some FIEs to pursue exit strategies from the Chinese market through various mechanisms and means. Factors contributing to these decisions include economic conditions, market dynamics, disputes arising from joint ventures or investments, and other legal considerations. M&A activities emerge as a favoured exit strategy, offering advantages not only to the exiting FIE but also to the entities that are merged with. Nonetheless, other exit methods, such as the dissolution and liquidation of FIEs, as well as compulsory and bankruptcy liquidations, are also utilised, particularly during economic downturns.

Outlook for 2024 and Beyond

Referring to the aforementioned trends, it is likely that FDI inflows into China may not see any significant increases soon due to the current economic and business climate in China. However, one of the main legal developments to monitor for 2024 is the introduction of the New Company Law, which impacts companies, including FIEs, and the exit strategies they can employ.