I. Introduction
There was never much doubt that China's accession into the World Trade Organisation (WTO) in 2001 would inspire increased foreign investment in the emerging giant of the world economy. Foreign investors were enlivened by the expectation that China's implementation of its WTO accession commitments would enable them improved access to a key market supported by an increasingly predictable and reliable legal framework. Interestingly, while the past six years have seen significant developments in both China's commercial law structure and the amount of foreign investment in China, the success of China's liberalisations has engendered concerns about the level of foreign penetration in the Chinese market.
Further, some observers argue that, despite the frantic pace of legal reform, China's regulatory structure for foreign-funded mergers and acquisitions (M&A) is struggling to keep up with the emerging market for cross-border corporate control.1It was against the backdrop of such concerns that the Provisions on Acquisition of Domestic Enterprises by Foreign Investors (New M&A Provisions)2came into effect on 8 September 2006, replacing the Tentative Provisions on Acquisitions of Domestic Enterprises by Foreign Investors (Tentative M&A Provisions),3which had been in force since 12 April 2003.
It is clear that the New M&A Provisions aim at addressing many of the concerns that arose in relation to the Tentative M&A Provisions. For instance, the New M&A Provisions look to stem the growing apprehension that ownership of Chinese business assets is being shifted offshore for less than fair value,4and they also attempt to curb the illicit overseas 'round-tripping' of China-sourced investment to take advantage of foreign investment incentives.5Nonetheless, pending the unconfirmed issuance of detailed implementing rules to support the New M&A Provisions, the general consensus is that the New M&A Provisions have done little to reduce the considerable risks involved in conducting M&A in the Chinese market.
This article begins with a brief explanation of recent regulatory developments relevant to M&As in China and goes on to provide a basic analysis of the various structuring options available for M&A in China. This article also comments on how foreign investors can be proactive in managing the risks associated with M&A in China.
II. Recent Regulatory Developments Relevant To M&A
Over the past two years, China has experienced a period of significant legislative and regulatory development aimed at providing a platform for orderly public and private M&A activity. With respect to public M&A, over this period the Chinese authorities have accelerated the share desegregation reform program,6imposed and lifted a moratorium on new share issuances, and encouraged foreign investment in the form of Qualified Foreign Institutional Investors (QFIIs) participation7and foreign "strategic" investment.8On the private M&A side, in addition to the New M&A Provisions and other relevant new regulations, Chinese legislators have extensively revised the PRC Company Law 9and amended the PRC Securities Law. 10
Chinese authorities have subsequently contradicted such developments by adopting a more restrictive regulatory stance. For instance, the Chinese business press previously reported that the National Development and Reform Commission (NDRC) was compiling a list of industries and enterprises that are off-limits to foreign acquisitions.11The list reportedly covers major Chinese enterprises in the machinery manufacturing sector as well as industries deemed critical to China's "economic security."
In the securities sector, the CSRC has placed a year-long ban on foreign investment in China's brokerage industry. Interestingly, when the CSRC released notice of the ban in September 2006, the Chairman of the CSRC, Shang Fulin, stated that China had already satisfied its WTO obligations on joint ventures in the securities sector, notwithstanding the fact that under current regulations foreign stakes in Chinese brokerages are capped at 20% for existing firms and 33% for new joint ventures, well below the 49% stipulated under China's WTO commitments. Similar restrictions also apply in the banking sector, among others.12
The regulatory landscape for M&As in China is constantly evolving,13and foreign investors must keep abreast of these changes in order to adequately protect their interests.
III. Regulating M&A Transactions
Given the increasing appetite for M&A activity in China,14it is easy to overlook the pervasive approval requirements that remain a distinctive feature of Chinese M&A transactions. In Chinese M&A transactions, the involvement of government agencies is not limited to monitoring the economic consequences of a deal (such as capitalization or competition concerns), but rather extends to reviewing and approving deal-specific arrangements in which they may be both the regulator and the vendor (or closely associated with the vendor).15Consequently, it is important to be aware that Chinese M&A transactions are frequently subject to approval requirements, which involve government discretion and which are often unpredictable and time-consuming.
Recent exercises of government discretion have raised concerns about a move towards Chinese trade protection. For instance, Carlyle Group's attempted purchase of an 85% stake in Xugong Construction Machinery Group stalled in the face of criticism about the low selling price of state-owned assets and concern over foreign capital controlling China's leading machinery manufacturers. Carlyle subsequently cut the size of its desired stake in the Chinese construction equipment maker to, first, 50% and then 45%.16Following the public uproar over Carlyle's original bid, the Chinese government announced that makers of construction equipment must consult Beijing before selling large stakes to foreigners.
Foreign investors can place themselves at an advantage by understanding that the discretionary approvals required for M&A transactions in China are far more than procedural formalities, and by building relationships of trust ( guanxi ) with influential players in the approval process. While proactive and early management of all government and semi-government stakeholders will not guarantee the consummation of an M&A transaction in China, it is an indispensable part of the process.
IV. Structuring M&A Transactions
Chinese law recognises the traditional acquisition structures applied in most jurisdictions throughout the world. Under Chinese law, M&A transactions can be carried out through an equity purchase, an asset acquisition or a statutory merger. Nonetheless, each structure is characterised by its own salient challenges.
A. Equity Acquisitions
Foreign investors may directly or indirectly purchase equity (either registered capital or shares) in a target registered in China. Like equity acquisitions in most other jurisdictions, in this type of acquisition the legal nature of the target generally does not change; ownership alone changes.
1. Direct Equity Acquisitions
In a direct equity acquisition, the foreign investor acquires equity in a domestic enterprise or a foreign-invested enterprise (FIE) from the existing Chinese or foreign equity holders pursuant to a share purchase agreement (or its equivalent document) or from the target through a subscription for new equity.17
Foreign investors are required to comply with the limitations on foreign ownership interest in different industries as outlined in the Guidance Catalogue for Foreign Investment Industries (the "Catalogue").18The Catalogue divides industries and investment projects into three main categories; namely, encouraged, restricted, and prohibited. According to the Catalogue, foreign investors are prohibited from conducting equity (or asset acquisitions) involving those PRC domestic companies that are engaged in industries in which foreign investment is prohibited. Also, an M&A transaction can only be carried out in a restricted industry if the majority ownership interest or control remains with Chinese domestic shareholders after the acquisition. Investments not specifically set out in the Catalogue are deemed to be permitted.
Where the target is an existing FIE, a direct equity acquisition requires the discretionary approval of the FIE's original Chinese examination and approval authority or potentially a higher authority if the target is restructured by way of capital injection. Any other investors in the FIE will have a statutory pre-emptive right to acquire the interest being transferred.
Chinese law now also permits existing FIEs to make equity acquisitions in another FIE or a purely domestic enterprise if certain conditions are satisfied.19
Compared to an asset acquisition, a direct equity acquisition is generally simpler and less burdensome from a regulatory perspective. This is because the foreign investor does not need to specify the preferred assets and businesses of the Chinese target company or execute individual assignment contracts for the assets and businesses.20
However, as opposed to indirect equity acquisitions, direct acquisitions are subject to approval by the Chinese authorities. This may be particularly onerous for direct acquisitions in sensitive industries or acquisitions of companies that are considered to be strategically important to the Chinese economy (as was the case with Xugong).
2. Indirect Equity Acquisitions
If the Chinese target company is an existing FIE, a foreign investor may acquire or increase control of the Chinese target company through the offshore purchase of some or all of a foreign party's interest in the FIE. Such a transaction is invariably conducted offshore in the jurisdiction of the FIE's existing foreign investor and generally does not attract Chinese legal implications, except in certain circumstances pursuant to the nascent antitrust review regime in China.
Typically, Chinese government approvals are not required for this type of acquisition because the FIE's registered equity holder does not change. Further, this form of transaction will not trigger the statutory pre-emptive rights of the other investors. For these reasons, among others, this is generally the preferred acquisition method for foreign investors, particularly when the target equity is held by a special purpose vehicle without other assets.
B. Asset Acquisitions
A foreign investor may purchase directly part or all of the business and assets of a Chinese target company. However, Chinese law does not permit a foreign company to operate assets directly in China, so such asset acquisitions are generally allowed only where the foreign purchaser has established an FIE in China, be it a new FIE set up in connection with the acquisition or an already operating FIE. Where a new Chinese acquisition vehicle is established in conjunction with the acquisition, the capital contributions made for the establishment of the acquisition vehicle can be used as consideration for the acquisition of the target assets.
Asset acquisitions in China epitomise the sagely advice of the fox in Saint-Exupery's The Little Prince - "what is important in life is what is invisible." Even after providing the authorities with all of the necessary documents, there is no guarantee that the required approvals will be granted. Consequently, considerable government liaison work may be necessary for this type of transaction, and having good relations with the relevant government authorities is crucial. One particular transaction familiar to the author involved facilitating the meeting of minds among at least six different government authorities. Given the paucity of interaction that usually takes place between separate Chinese government authorities, this was not an easy task. For instance, it may be necessary to obtain approvals from local environmental authorities, local land administration bureaux, local labour bureaux, just to name a few.
Foreign investors should be aware that in China asset or business purchases invariably give rise to complexities to do with transfer of employment, dealing with creditors, obtaining customs approvals, securing land use rights, and (where applicable) handling state-asset valuations, among other issues. Equity acquisitions also attract some of the above-mentioned difficulties. It is important that foreign investors seek legal advice on how best to manage these concerns.
C. Mergers and Divisions
The Provisions on the Merger and Division of Foreign Investment Enterprises provide a basis for merging FIEs and domestic enterprises. Spin-offs and divisions by dissolution are also sanctioned under Chinese law, but cross-border mergers are currently unavailable, so it is not possible to directly merge a foreign entity with a domestic company (including FIEs).
Foreign investors may only conduct mergers between two FIEs, or between an FIE and a domestic company. In practice, such mergers are rare because of complications associated with the multi-step approval process.
V. Conclusion
China's remarkable economic growth in recent years has firmly established China as a significant M&A market. Foreign investors are becoming increasingly attracted to this market where the plethora of rapidly expanding businesses present enormous potential as M&A targets. However, notwithstanding important new liberalisations, the legal environment for Chinese M&A continues to present its idiosyncratic challenges, and players in the market will need to be well prepared in order to negotiate the many obstacles that continue to exist for M&A transactions in China.
Published December 1, 2007.
