Chinese puzzles

In M&A transactions the principal terms negotiated by the parties are usually the structure, price, representations, warranties and undertakings and indemnities. Whereas in most jurisdictions parties are at liberty to agree on these terms, in China the outcome of the negotiations between Chinese and foreign parties may not be as final as hoped for.

If an M&A transaction involves foreign investors merging or acquiring a domestic (Chinese) enterprise through the purchase of equity or assets, the parties’ agreement is subject to government review, and possibly unilaterally imposed change. The Regulations Regarding the Acquisition of Domestic Enterprises by Foreign Investors (the regulations), effective since 8 September 2006, replace earlier regulations and impose other mandatory requirements such as antitrust reviews, creditor notifications, valuations and mandated payment schedules.

Depending on the structure and purpose of the acquisition, national and local government agencies may be involved at various points in the M&A process, including the Ministry of Commerce (Mofcom), the provincial-level commerce authority (provincial Coftec) and the China Securities Regulatory Commission (CSRC).

The mechanics
China accepts the principle that the liabilities of the Chinese enterprise in an equity deal are inherited by the foreign investment enterprise (FIE) established after the completion of the transaction, and that those in an assets deal remain with the Chinese enterprise.

However, in the event of an assets deal, the Chinese enterprise must notify its creditors of the impending transaction and formulate a plan for the disposition of the existing employees of the Chinese enterprise. The regulations require that a valuation of the equity or assets to be transferred in the deals be carried out and that the transaction price is not significantly different from the outcome of the valuation exercise.

The freedom of the parties to an M&A transaction to set their own payment schedule is restricted by the mandatory requirement that payment must be made in full within three months from the official date of establishment of the FIE. Investors may apply to the Mofcom for an extension, with 60 per cent paid within the first six months and the remainder in full within one year.

Having all documents completed may not signal the end of the process, as the provincial Coftec may unilaterally impose changes that could impact on the transaction.

‘Round trip’ investments
The regulations impose new restrictions on ‘round trip’ investment – the use of an overseas company established or controlled by a Chinese company, enterprise or individual to acquire an affiliated Chinese company. The FIE established as a result of an M&A transaction involving round trip investment is not eligible for the preferential policies applicable to FIEs without the injection of additional foreign funds. Such round trip investment now requires Mofcom approval regardless of the approval level that would otherwise be applicable.

Acquisitions involving affiliated companies
Further disclosure concerning connected party acquisitions is required. If both parties are controlled by a single entity, the identity of the entity should be disclosed and an explanation provided as to the purpose of the acquisition and whether the transaction value represents the price recognised by the market. The regulations expressly prohibit the evasion of these requirements by means of arrangements such as trusts or nominee shareholders.

Share consideration
The regulations clarify the permitted use of share consideration, which should make the use of share consideration practically feasible, although subject to significant restrictions. The foreign investor whose shares are to be used must satisfy certain restrictive criteria:

  • investor must be registered lawfully and it and its management shall not have been penalised by its competent supervisory authority in the most recent three years;
  • he jurisdiction in which the investor is registered must have a complete corporate law system;
  • he investor must be a listed company, unless it is a special purpose vehicle (SPV); and
  • he jurisdiction where the investor is listed must have a complete securities exchange system.

    The share price of the consideration shares must also have been relatively stable in the year prior to the transaction. The Chinese company or its shareholder(s) must further appoint a China-registered intermediary organisation to investigate and verify compliance with the regulations. The opinion of the China-registered intermediary will be required in the approval process.

    Interim approvals are used to monitor these transactions. These transactions require sequential approval first for use of share consideration and then for overseas investment by the Chinese party receiving the shares. The use of share consideration is not a shortcut to offshore investment for Chinese entities.

    Special reporting
    The regulations also require that acquisitions involving key industries impacting on national economic security or resulting in the change of control of an entity with a well-known Chinese trademark or brand be reported to the Mofcom. No guidance is provided on the meaning of such terms, making them liable to be interpreted by the approval authorities as expediency may require. Failure to satisfy the reporting requirement can result in the unwinding of an otherwise properly approved transaction.

    Special purpose vehicles
    The regulations further regulate the use of shares of SPVs, overseas companies held by Chinese citizens for listing purposes, in the restructurings of Chinese enterprises where the ultimate purpose is an offshore listing of the SPV. Fairly stringent criteria have been introduced for such reorganisations.

    While the SPV does not need to be listed at the time of the transaction, a listing must take place within a year or it will be reverted otherwise. The transaction must be approved by both the Mofcom and the CSRC (previously only Mofcom approval was required). Should a foreign enterprise holding interests in an SPV be used for listing purposes, the regulations relating to SPVs also apply, and a detailed explanation of the trading arrangement between the SPV and the overseas company regarding the equity of the acquired Chinese company must be submitted to the Mofcom for approval.

    itrust review
    While China currently has no antitrust law (one is anticipated in the near future), antitrust review and other market concentration issues form a part of the M&A review process. Foreign investors in an merger or acquisition must submit a report to the Mofcom or the State Administration of Industry and Commerce (SAIC) if any investor satisfies the criteria for antitrust review, including, among others, a market share in China of 25 per cent or more following the proposed deal or a turnover within China exceeding Rmb1.5bn (£1m) a year. Offshore transactions possibly resulting in the same are also subject to antitrust review. Even when the investor does not necessarily meet the criteria for an antitrust review, participating foreign investors may be required to file an antitrust report upon a petition to the Mofcom or the SAIC by a Chinese competitor, related administrative department or industry association.

    Foreign parties undertaking M&A transactions in China must be aware of the procedural requirements and legal restrictions that govern these transactions under People’s Republic of China law. The legal provisions make careful planning and structuring of the transactions necessary so as to remain within the law and to limit the time needed to complete the official review process. Regardless of such preparations, an element of uncertainty always pertains to the process as a result of the mandatory government review and parties should be aware that the outcome of a deal may be different from what they had originally agreed.

    ki Cheung is head of the China practice and Erik Leyssens is a senior associate at Deacons, Hong Kong