China’s New Cross-Border Merger & Acquisition Regulations Seek to Close Some Doors and Open Others in Furtherance of 11th Five-Year Plan for Utilizing Foreign Investment
March 21, 2007
Adam Charles Ritter - Los Angeles
The Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors (New Regs)1 were promulgated and came into force late in 2006 in China by joint order of the following:
• China’s Ministry of Commerce (MOFCOM)
• China Securities Regulatory Commission (CSRC)
• State Administration of Foreign Exchange (SAFE)
• State Administration for Industry and Commerce (SAIC)
• State-owned Assets Supervision and Administration Commission of the State Council (SASAC), State Administration of Taxation (SAT)
These regulations superseded the Interim Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors that were promulgated by MOFCOM’s predecessor agency in 2003 (Old Regs).
In commenting on the New Regs, the Organization for Economic Co-operation and Development (OECD) recently observed that, “The new policy towards cross-border mergers and acquisitions is explained in the 11th five-year plan for utilizing foreign investment, published by the National Development and Reform Commission (NDRC) on November 9, 2006.2 This states that priority will be given to quality rather than quantity of foreign investments, that emerging monopolies by foreign-invested enterprises are posing a potential threat to China’s economic security and that foreign businesses are harming Chinese enterprises’ capacity for independent innovation. The plan sets forth a clear industrial policy that prioritizes geographical areas, industrial sectors, levels of technology, environmental protection and efficient use of natural resources. In response to perceived rising concern over foreign acquisitions of leading Chinese firms in critical sectors, the plan provides for increased supervision of sensitive acquisitions to ensure that what are termed ‘critical industries and enterprises’ remain under Chinese control.”3
The balance of this article highlights some examples of how, within that framework for cross-border mergers and acquisitions (Cross-Border M&A), the New Regs close or enable the closing of some doors while they open others. and then offers some observations.
Doors Closed or Able to Be Closed
Limitations on Round Tripping
The New Regs seek to limit “round tripping,” i.e., the practice by owners of a Chinese enterprise that has no foreign owners (Domestic Enterprise) of running their investments in the Domestic Enterprise through an offshore holding company in order to obtain certain taxation and other benefits afforded to foreign-invested Chinese enterprises (FIEs) under Chinese law. Accordingly, the New Regs provide that:
• Except as otherwise provided by China’s other laws and administrative regulations, a Chinese enterprise will enjoy FIE status only if 25 percent or more if its registered capital comes from foreign investors. To facilitate enforcement of this, a Chinese enterprise with foreign investment after a Cross-Border M&A transaction accounting less than 25 percent of its registered capital will be issued an FIE business license (Business License) and a forex registration certificate (Forex Certificate) but each will be annotated with the phrase “foreign investment ratio less than twenty five percent (25 percent).”
4
• Approval from Central MOFCOM (i.e., MOFCOM’s national headquarters in Beijing) is required for an offshore entity owned or controlled by one or more Chinese enterprises or nationals to acquire a controlling interest in a Domestic Enterprise that is “affiliated” with such Chinese enterprise(s) or national(s).5
No Hiding Affiliation of Parties and Their Transactions Inconsistent With FMV
If parties to a Cross-Border M&A transaction are under the actual control of a single person, those parties must disclose to the examination and approval authority such actual control, and explain whether the purpose of the transaction and its appraised value are consistent with implementing sale of the Domestic Enterprise’s equity or assets for fair market value. The parties may not circumvent the foregoing through trust, nominee, or other methods.6
Protection of Key Industries, National Economic Security, Famous Trademarks and Time-Honored Chinese (Trade) Names
MOFCOM approval must be sought by a party to a Cross-Border M&A transaction that (i) will result in a foreign investor obtaining “actual control rights” over a Domestic Enterprise, and (ii) involves any of the following:
• “key industry”
• transfer of a Domestic Enterprise’s actual control over a “famous trademark” or “time-honored Chinese [trade] name”
• factors that have or may have an impact on China’s “national economic security”
The New Regs do not define or explain any of the phrases quoted in the three items directly above. Notably, if MOFCOM approval is not sought in advance with respect to a Cross-Border M&A transaction that has or may have a “significant” impact on China’s national economic security, then MOFCOM and other relevant authorities may require the involved parties to terminate the transaction, transfer relevant equity or assets, or take other effective measures in order to eliminate any impact of the transaction upon China’s national economic security.7
Approval Authorities Given Latitude by Subjective Criteria for Approval
Some of the criteria to be met if a Cross-Border M&A transaction is to be approved are subjective, leaving the approval authorities significant latitude when evaluating the transaction. These criteria include, for example, that a foreign investor acquiring a Domestic Enterprise shall do the following:
• “… adhere to the principles of fairness, reasonableness, compensation of equal value, and good faith,”8
• “… not cause over-concentration to eliminate or restrict competition, disturb socio-economic order, damage the public interest, or cause the loss of state-owned assets,”9
• not only satisfy applicable Chinese laws and regulations governing investor qualifications, but shall also satisfy “industrial, land use, environmental protection, and other policies”10
The New Regs do not define or explain any of the subjective terms in the phrases quoted in the three criteria listed directly above.
Vaguely Defined Category of Cross-Border M&A Transactions Approvals Removed From Provincial to Central MOFCOM
The New Regs require provincial MOFCOM authorities to forward to Central MOFCOM for approval all applications for Cross-Border M&A transactions that establish an FIE “of a particular type or industry that requires MOFCOM examination and approval under other laws, administrative regulations, and rules” (Special FIE).11 However, there is no published list or set of guidelines stating what constitutes a Special FIE.12
Doors Opened
Procedures for Cross-Border M&A Transactions Clarified
The New Regs set forth somewhat lengthy but specific procedures to be followed in order to accomplish a legally effective Cross-Border M&A transaction in China.13 They also specify various approvals required from MOFCOM, SAIC and SAFE approval.
Share Swaps Now Permissible Within Limited Circumstances
Before promulgation of the New Regs, no express statutory guidance existed concerning the use of equity interests in a foreign company to acquire equity interests in a Domestic Enterprise (Share Swap), and applications for Share Swaps were generally rejected. The New Regs specifically authorize Share Swaps upon the satisfaction of certain conditions, including but not limited to the following:
• The Domestic Enterprise or its owner must hire an intermediary company registered in China and having certain specified qualifications to serve as a consultant (M&A Consultant) to perform due diligence research, and issue a report setting forth its “professional opinion,” regarding the authenticity of the documents filed for application, the financial status of the foreign company, and the proposed transaction’s compliance with the requirements of Article 14 (which prohibits sales of the Domestic Enterprise’s stock for manifestly less than its appraised value), and Articles 28 and 29 (which specifies various requirements to be met by the foreign company the shares of which are to be exchanged for those of the Domestic Enterprise).14 Among the qualifications an M&A Consultant must have is “the ability to investigate and analyze the legal systems used in the foreign countries where the foreign company is organized and listed.”15 This seems to require that the M&A Consultant be a foreign law firm registered to practice in China and having specific expertise in the applicable foreign countries.16
• The foreign company must be a publicly listed company, and the listing must be in a jurisdiction with a sound securities trading system, but may not be an over-the-counter listing.17
• The trading price for the foreign company’s shares must have been “stable” during the most recent year.18
For Share Swaps where one of the entities whose equity interests being exchanged is a Special Purpose Vehicle (defined below), in lieu of the latter two conditions directly above, a more extensive set of conditions apply. A Special Purpose Vehicle (SPV) is a foreign company that is directly or indirectly controlled by one or more Chinese entities or nationals (Chinese Owners) in order to bring about the foreign public listing of equity interests of a Domestic Enterprise beneficially owned by those Chinese Owners. The following are some of the special conditions for a Share Swap involving the exchange of equity interests in an SPV (SPV Share Swap):
• The securities regulatory authorities of the jurisdiction where the SPV is listed must have entered into a memorandum of understanding on regulatory cooperation with the CSRC, and a cooperative relationship between such authority and the CSRC must remain.19
• The Domestic Enterprise must have a “healthy and complete governance structure and internal management system,” a “complete system for business operation,” and a “good ability to maintain continuous operations.”20
• The total value of the offering price for the equity interests of the SPV to be listed abroad must equal or exceed the value (as determined by “the relevant Chinese assets appraisal authority”) of the corresponding equity interests of the Domestic Enterprise to be merged or acquired.21
The New Regs also set forth an extensive set of specific procedures to be followed in order to accomplish a Share Swap or an SPV Share Swap. These include obtaining various Central MOFCOM, SAIC and SAFE approvals. But when an SPV Share Swap involves a new foreign listing of the SPV or of the SPV’s affiliate (whichever, an SPV Listing), CSRC approval of the overseas listing is also required.
While the New Regs authorize Share Swaps and SPV Share Swaps, they also impose a number of significant limitations on such transactions, including, for example:
• Applicable Only to Share Swaps (Not SPV Share Swaps) An approved Share Swap transaction will be automatically unwound, and the resulting FIE will be automatically converted back to a Domestic Enterprise, unless both of the following have occurred within six months after the SAIC’s issuance of the FIE’s business license:
(i) consummation of the approved Share Swap transaction; and
(ii) application by the Domestic Enterprise to MOFCOM for removal of MOFCOM’s conditional pre-consummation approval.
• Applicable Only to SPV Share Swaps An approved SPV Share Swap transaction involving an SPV Listing will be automatically unwound, and the resulting FIE will be automatically converted back to a Domestic Enterprise, if the SPV Listing is either:
(i) not consummated within one year after the SAIC’s issuance of the FIE’s business license; or
(ii) consummated timely but the FIE does not, within 30 days of consummating the SPV Listing, report to MOFCOM the fact that the SPV Listing has been consummated and submit to MOFCOM a plan stating how the financial proceeds from the SPV Listing will be repatriated to China.22
To facilitate enforcement of the limitations on SPV Share Swaps set forth in (i) and (ii) directly above, a Domestic Enterprise’s application to undertake an SPV Share Swap transaction must be accompanied by various specified documents signed by the Domestic Enterprise’s legal representative that (if used) would restore the Domestic Enterprise’s pre-transaction equity structure and otherwise unwind the SPV Share Swap transaction. With respect to the limitation on SPV-Share Swaps set forth in (ii) above, the New Regs provide that the financial proceeds of an SPV Listing may be repatriated through: (a) “providing Domestic Enterprise commercial loan,”
23 (b) “merging [or] acquiring Domestic Enterprise,”24 or (c) establishing a new FIE in China.
Any profits, dividends or forex income earned by a Domestic Enterprise or Chinese national as a result of an SPV Listing must be repatriated to China within six months of the date such income is earned.25
MOFCOM, SAIC, and SAFE approvals are needed not only before consummation of an SPV Listing, but also after it.
Chinese Nationals May Continue to Hold Interest in Domestic Entity Converted to FIE
Prior to the New Regs, a Chinese national and a foreign investor could not jointly own a Chinese enterprise. Under the New Regs, where a Domestic Enterprise is converted into an FIE upon one or more foreign investors acquiring a partial interest in the Domestic Enterprise, then, “with permission,” any Chinese nationals who were owners of the Domestic Enterprise before the acquisition may after the acquisition remain owners of the entity.26
Scope of Transactions Subject to Antitrust Review Narrowed
The scope of antitrust provisions of the New Regs is similar to the scope of the Old Regs’ antitrust provisions, except that effects “on the national economy, the people’s livelihood, and national economic security” are no longer factors that may be considered in evaluating the antitrust compliance of a Cross-Border M&A transaction.
Government Employee Integrity and Protection of Party Trade Secrets
The New Regs expressly provide that functionaries of relevant government organs must be loyal to their post, perform their duties according to law, not utilize their position to obtain any improper benefit and keep confidential the trade secrets to which they have access.
Concluding Observations
The New Regs limit round tripping; prohibit undisclosed affiliations among parties to Cross-Border M&A transactions; protect key industries, national economic security, and famous trademarks and time-honored Chinese trade names; and empower approval authorities through the use of subjective approval criteria and through the removal from provincial to Central MOFCOM of approval authority for a vaguely defined category of Cross-Border M&A transactions. By doing so, China has made it more difficult for Chinese entities and nationals to engage in round tripping and otherwise hide their involvement in Cross-Border M&A transactions, and has given approval authorities a number of opportunities to prevent or force the restructuring of Cross-Border M&A transactions on a case-by-case basis.
The New Regs also provide for the draconian consequence of post-consummation unwinding of a given Cross-Border M&A transaction in three situations:
(i) actual or potential impact on national economic security where MOFCOM approval is not sought in advance
(ii) certain consummation or MOFCOM approval deadlines are not met for a Share Swap
(iii) certain consummation or MOFCOM reporting deadlines are not met for an SPV-Share Swap
As such deadlines other than the MOFCOM reporting deadline could potentially fall beyond the control of the parties to a Cross-Border M&A transaction, the resulting risk that a Cross-Border M&A transaction be unwound post-consummation may have an unintended chilling effect upon Cross-Border M&A transactions.
Nevertheless, the New Regs create important new opportunities to undertake Cross-Border M&A transactions by specifying procedures for effecting such transactions, including through Share Swap and SPV Share Swap transactions not previously contemplated by Chinese law, by enabling Chinese nationals to obtain permission to continue holding equity interests in Domestic Enterprises that are converted into FIEs, by narrowing the scope of antitrust review, and by requiring government employees dealing with Cross-Border M&A transactions to act with integrity and to protect parties’ trade secrets.
In so doing, the New Regs effectively preclude, or enable relevant Chinese authorities to prevent, certain Cross-Border M&A transactions, but they also make possible other Cross-Border M&A transactions that were previously discouraged or prohibited.
For more information, e-mail Adam C. Ritter at adam.ritter@hklaw.com or call toll free, 1-888-688-8500.
1 Citations in this article are to the New Regs unless otherwise noted.
2 Recent Developments in China’s Policies Towards Cross-Border Mergers & Acquisitions, OECD (Dec. 2006)(“OECD Report”), p. 2. The OECD Report includes here a footnote numbered “4,” which reads, “Xinhua News Agency, 9 November 2006 and http://www.ndrc.gov.cn. The term ‘11th five-year plan’ is misleading because this is the first five-year plan for utilizing foreign investment to be published in China and it is unlikely that foreign capital utilization was included in all earlier economic plans.”
3 OECD Report, p. 2.
4 Article 9.
5 Article 11.
6 Article 15.
7 Article 12.
8 Article 3.
9 Id.
10 Article 4.
11 Article 10.
12 The American Chamber of Commerce in the People’s Republic of China (Am-Cham) in its Preliminary Questions/Issues/Comments Regarding the [New Regs], dated September 8, 2006 (Preliminary Comments), specifically asks whether such a list or set of guidelines will be provided in the future. Also, such a list is to be distinguished from the rather well known Foreign Investment Industrial Guidance Catalogue (referenced in Article 4), as the latter merely lists certain industries and for each listed industry specifies whether foreign investment in a Chinese enterprise engaged in such industry is prohibited or limited to a specified percentage.
13 Articles 21-54, and 56.
14 Articles 14, 28, 29, 30 and 31.
15 Article 30.
16 Am-Cham has made this very observation and is seeking confirmation. Preliminary Comments, pp. 6 and 7.
17 Articles 28 and 29(3).
18 Unfortunately, the term “stable” is not defined.
19 Article 40.
20 Article 41.
21 Article 43.
22 Articles 47 and 48.
23 The New Regs do not make clear whether such loans may be made to any Domestic Enterprise, or only that Domestic Enterprise which is converted to an FIE through the Cross-Border M&A transaction giving rise to the SPV Listing.
24 The New Regs do not make clear whether such merger or acquisition may be of any Domestic Enterprise, or only that Domestic Enterprise which is converted to an FIE through the Cross-Border M&A transaction giving rise to the SPV Listing.
25 Article 48.
26 Article 57. The New Regs do not specify from whom such permission must be obtained, or what standards are to be satisfied in order to obtain such permission.