Mergers and Acquisitions in China, 2004
The increased pace of M&A activity has been fuelled by China’s economic reforms. China’s accession to the World Trade Organisation (WTO) has opened previously closed industry sectors to foreign investment, and operating restrictions previously imposed on enterprises with foreign investment have been gradually lifted, permitting greater access to the Chinese domestic market. With the continued strong growth of the Chinese economy, M&A transactions offering immediate market access are becoming an increasingly attractive alternative to green field investments.
Contemporaneously with this market reform, China has been restructuring its state-owned asset holdings. In a few industrial sectors, the state is encouraging state-owned companies to consolidate into large integrated conglomerates, which are intended to be global leaders in their fields, while in other sectors, the state is actively seeking to reduce the level of its equity holding. Consequently, a large number of state-owned enterprises (SOEs) are being made available for restructuring or partnering with foreign firms. These new potential targets offer foreign investors greater market entry options.
This article provides a broad overview of the current status of M&A practice in China, including the regulatory framework, structuring options, target types and recent regulatory developments.
Government agencies play an important role in Chinese M&A transactions, and an official approval is required in connection with most foreign investment transactions. Pervasive approval requirements are a distinctive feature of doing business in China. The entry of foreign capital into the Chinese economy remains heavily regulated.
The discretionary approvals required for an M&A transaction are not mere formalities. Considerable effort may be required to obtain the requisite approvals. Understanding the applicable regulatory framework and the government’s role in the approval process is an important step in successfully concluding transactions in China.
Several government agencies play a key role in M&A transactions. The Ministry of Commerce, formerly the Ministry of Foreign Trade and Economic Cooperation, is the primary regulator of foreign investment and has general supervision and approval authority over M&A transactions. The State Development and Reform Commission (“SDRC”), which recently assumed the responsibilities of the former State Economic System Restructuring Office, is responsible for both approving the feasibility study reports of foreign investment projects and supervising the restructuring of state-owned enterprises. These agencies are the primary regulators of M&A transactions.
In addition, other agencies often play a role in M&A transactions. The recently formed State Owned Assets Supervision and Administration Commission (“SASAC”) has supervisory authority over state-owned assets. It is involved in transactions targeting state-owned enterprises. The China Securities Regulatory Commission (“CSRC”) is responsible for monitoring and regulating China’s capital markets. It is involved in transactions targeting listed companies. The State Administration of Foreign Exchange (“SAFE”), which regulates foreign exchange transactions, is often involved in matters concerning consideration.
It should be noted that China has recently undertaking a major restructuring and streamlining of the various government agencies involved in the M&A process. As a result, some regulations reference agencies that no longer exist and whose functions have been assumed by other agencies.
The general regulatory framework applicable to foreign investment in China is also applicable to foreign related M&A transactions. A foreign company is not permitted to directly operate a business in China. It must do so through a foreign investment enterprise (“FIE”). There are currently four types of FIE in China: sino-foreign equity joint ventures, sino-foreign cooperative joint ventures, wholly foreign-owned enterprises and foreign investment enterprises limited by shares. Although each type of FIE has its own distinctive features, FIEs share many common characteristics and are generally limited liabilities companies.
Investment projects are classified by industry sector in the Catalogue for the Guidance of Foreign Investment as “encouraged”, “permitted”, “restricted” or “prohibited”. The catalogue classification impacts both the investment approval process and the permissible level of foreign equity holding. Majority Chinese equity is required in some restricted industry sectors, while in other restricted sectors, wholly foreign-owned enterprises are prohibited. A preliminary step in any M&A transaction or China investment project is to confirm the status of the industry sector in the foreign investment catalogue.
Over the past two years, China has enacted a preliminary regulatory framework for M&A transactions. The framework, while not complete, provides greater guidance for foreign investors engaging in M&A transactions and standardises practices that have developed on an ad hoc basis over the last several years. Under China’s civil law legal system, even basic types of business transaction may be governed by fairly detailed regulations.
The new regulations establish a basis for using conventional acquisition methods to acquire most types of enterprise in China. Regulations now permit foreign investors to engage in asset or equity acquisitions of FIEs, domestic enterprises, state-owned enterprises and listed companies. The range of permissible targets has been vastly expanded, but distinct regulatory regimes are applicable to acquisition of each type of entity. Such entity differentiated legal treatment remains fairly common in China.
The specific approvals required for an M&A transaction will depend on the deal structure, the nature of the target, and the value of the transaction. As a general matter, however, transactions involving projects with a total investment amount of US$30 million or more typically require the approval of the Ministry of Commerce, while projects with a total investment amount of under US$30 million can generally be approved by the Ministry’s provincial or lower level branches. There are exceptions to this general rule depending on the particular classification of the project, permitting lower level approvals in some cases, while requiring higher level approvals in others.
Depending on the industry sector, the approval of other specialised administrative agencies, such as the Ministry of Information Industry, may also be required. If the target company is a state-owned enterprise, the transaction will generally require the approval of the Ministry of Commerce, the SDRC and the SASAC. Transactions targeting listed companies require the involvement of the CSRC.
A foreign investor pursuing an M&A transaction in China has a choice of the traditional acquisition structures. An M&A transaction in China may be consummated through an equity purchase, an asset acquisition or a statutory merger. All three forms of acquisition are recognised under PRC law.
The preferred acquisition method will depend on considerations such as the financial condition of the target, the required government approvals, the necessity of third party consents, the transferability of the assets and the tax consequences of the structure.
A foreign investor may directly or indirectly acquire equity (either registered capital or shares) in a target from existing investors. In this type of acquisition, the legal nature of the target generally does not change; ownership alone changes. This acquisition method is generally the simplest and quickest to complete.
Equity acquisitions by a foreign investor may be carried out through an indirect offshore acquisition or as a direct acquisition PRC law now also permits operating FIEs to make equity acquisitions if certain conditions are satisfied.
Indirect Equity Acquisition
An indirect offshore acquisition is possible when the target is a foreign partyís equity interest in an FIE. In an indirect offshore acquisition, the foreign investor acquires equity in the FIEís offshore investor. This is generally the preferred acquisition method, when the target equity is the sole asset of a special purpose vehicle without other assets. Typically, PRC government approvals are not required for such acquisitions since the FIEís registered equity holder does not change. This form of transaction will also not trigger the statutory pre-emptive rights of the other investors.
Such a transaction may be handled as a typical share acquisition without implicating PRC legal issues.
Direct Equity Acquisition
In a direct acquisition, the foreign investor acquires equity in an FIE or domestic enterprise from the existing foreign or Chinese equity holders pursuant to an equity acquisition agreement or the target through a subscription for new equity. A direct equity acquisition in an FIE requires the discretionary approval of the Chinese examination and approval authority that originally approved the formation of the FIE. Any other investors in the FIE will have a statutory pre-emptive right to acquire the interest being transferred.
If the acquisition results in the introduction of foreign investment into a domestic enterprise, conversion into an FIE will also be required, and the approval process for the establishment of an FIE will be applicable. In such case, the legal nature of the target will change.
Equity Acquisitions by FIEs
Operating FIEs are now permitted to invest in other enterprises. The Interim Provisions on Domestic Investment by Foreign Investment Enterprises provides a basis for such subsidiary investments. The invested entity may either be another FIE or a domestic enterprise.
Sectoral restrictions on foreign investment are still applicable to such investments. The investing FIE must also satisfy certain criteria. For non-holding company FIEs, such investments may not amount to more than 50% of its net assets. The FIE’s registered capital must have been fully subscribed. The FIE must also have achieved profitability and have no record of unlawful activities.
A formal registration and approval process is applicable to such investments. For investments in “encouraged” and “permitted” industry sectors, the domestic company registration procedure may be used to validate the investment. This is a simpler and less time consuming process than obtaining Ministry of Commerce approval. For investments in “restricted” industry sectors, Ministry of Commerce approval is still required.
A different regulatory regime is applicable to foreign invested holding companies.
An M&A transaction may also be structured as an asset acquisition. In an asset acquisition, the acquirer may acquire select assets and liabilities of the target. There, consequently, is an opportunity to carve out unwanted assets and liabilities. Consideration is paid directly to the target, which maintains its separate legal existence. While time consuming, this method may be attractive given the difficulty of identifying with certainty the liabilities of PRC entities.
As a foreign company may not operate assets directly in China, a PRC acquisition vehicle is typically established simultaneously with the acquisition. The capital contributions made to the acquisition vehicle in connection with its establishment are used to acquire the assets directly from the target.
Considerable government liaison work may be necessary for this type of transaction. Agreements with creditors are sometimes required. Arrangements with the target’s workers will normally be examined during the approval process. In some cases, formal consultation with the target’s workers on their settlement arrangement may be required. While the worker settlement issues are the responsibility of the target, their handling may impact the progress of the transaction. Customs approval and the payment of supplemental duty may be required if the acquired assets are under customs supervision.
Statutory mergers are also sanctioned under PRC law. The Provisions on the Merger and Division of Foreign Investment Enterprises provides a basis for merging FIEs and domestic enterprises. Previously mergers took place largely on an ad hoc basis through liaison with local approval authorities. In a statutory merger, the acquiring entity succeeds to all of the assets and liabilities of the target by operation of law, while the existing investors’ equity is transformed into merger consideration. A merger under PRC law may be structured in a number of ways. The target may be merged into the acquirer or a new entity can absorb both entities.
A merger is subject to a number of conditions. The merger agreement must address certain statutorily required items. The merger candidates’ registered capital must have been fully contributed. Parties to a merger must also make arrangements for the employment of the original employees. Creditors are required to be notified and have the statutory rights to require debt repayment or the provision of adequate security as a condition to the consumption of the merger. The foreign investor in the merged company is required to hold a minimum of 25% of the post-merger company’s registered capital in order for it to enjoy FIE tax and customs benefits.
A merger is subject to a multi-step approval process. Preliminary approvals must be obtained from both the surviving and the dissolving entities’ approval authorities. A final approval is required from the surviving entity’s approval authority. Any existing subsidiaries of the merged entities must satisfy the applicable port-merger regulatory requirements. PRC law has a bias toward operating companies and certain conditions must be satisfied for a company to hold equity in a subsidiary.
The new M&A regulations have expanded the range of permissible targets providing greater guidance for acquisitions involving domestic companies and state-owned enterprises. These new general M&A regulations are not applicable to acquisitions targeting listed companies; such acquisitions are covered by separate regulations based on share classification. The new regulations also do not provide additional guidance on M&A activities targeting foreign investment enterprises, which are covered by the existing joint venture regulations. Since the State’s interest is less directly involved, acquisitions targeting FIEs are generally less heavily regulated. Special restrictions apply with respect to certain types of targets.
M&A transactions involving domestic targets are sanctioned under Chinese law. A standardised regulatory framework for domestic M&A transactions involving foreign investment has been recently established. The Interim Provisions on the Acquisition of Domestic Enterprises for Foreign Investors provides a mechanism for the acquisition of domestic equity or assets by foreign investors. A foreign investor may acquire equity in a domestic company from an existing domestic shareholder or pursuant to a capital increase. In either event, the domestic enterprise shall be transformed into an FIE.
The new regulations permit greater range of acquisition consideration, which now includes convertible foreign currency, in-kind assets, intangible assets, and lawfully earned renminbi, as well as sharesover which the investor has a disposal right. This wider range of consideration permits greater deal structuring flexibility. The possibility of using share consideration is a major development although SAFE approval is required for the use of such consideration. Payment is generally required within a year for a domestic asset acquisition.
These transactions are subject to discretionary PRC government approval, which should be granted within thirty (30) days of the submission of transaction documents. The investments resulting from such transactions must comply with China’s foreign investment industrial policies.
The acquisition of non-listed state-owned enterprises is also addressed in new regulations. The Interim Provisions on the Utilisation of Foreign Investment to Restructure State-owned Enterprises establishes a framework for foreign investment in State-owned enterprises and their transformation into FIEs.
A foreign investor may acquire an interest in a state-owned enterprise through the acquisition of an existing equity interest, the conversion of existing debt or the acquisition of the assets of the state-owned enterprise. A foreign investor may also subscribe to the registered capital increase of a state-owned enterprise.
The resolution of employee related issues is an important aspect of the acquisition process. The government pays particular attention to plans for the handling of existing employees. Worker settlement arrangements are typically required in connection with such transactions.
The reorganisation application for the use of foreign investment is required to be approved by the SASAC. The reorganised enterprise must then handle approval procedures related to the establishment of an FIE.
Foreign acquisitions of shares in listed companies are regulated with reference to the nature of the shares acquired. Most shares in China are not freely transferable. Shares are classified according to the entities authorised to hold them. Listed A shares, which are denominated in renminbi, may generally only be held by PRC nationals, while listed B shares, which are denominated in foreign currency, may generally only be held by foreign nationals. There are a few exceptions in each case. State owned shares are held directly by the State. Legal person shares are held by government entities authorised by the State.
The capital structure of PRC listed companies generally consists of a minority of tradeable listed shares and a majority of non-tradeable state-owned and legal person shares. This complex share ownership system has limited share acquisition opportunities. Recent regulatory changes, however, have expanded the range of permissible foreign share acquisitions.
Foreign M&A transactions targeting PRC listed companies are not common. Foreign investment in listed companies has traditionally taken the form of negotiated minority stakes, and has been for the purpose of establishing a strategic relationship or making a financial investment rather than for obtaining operating control.
The Administrative Measures on the Acquisition of Listed Companies, however, now provides a framework for the acquisition of listed companies by foreign investors. Recent regulations address the takeover of listed companies, which is defined as the acquisition of 30% of a listed company’s issued rather than listed shares. A takeover may be undertaken by agreement, public tender offer or market acquisitions on the stock exchange.
The regulations permit the use of non-cash consideration in a takeover, allowing more complex structuring arrangements involving equity consideration. CSRC approval is required for a takeover by agreement. A public tender offer to all shareholders is statutorily required after the 30% interest is acquired. It is unclear how the tender offer requirement will work for foreign investors in practice since foreign investors are prohibited from acquiring certain classes of shares.
The interaction between the general offer requirements and the share class ownership restrictions requires further clarification. The CSRC may waive the general offer requirement in its discretion.
Foreign acquisition of legal person shares in listed companies has been prohibited since 1995. The restriction, however, was lifted in 2003 pursuant to the Notice on Relevant Issues Regarding the Transfer of State-owned Shares and Legal Person Shares of Listed Companies to Foreign Investors. The Notice outlines a regulatory framework for the transfer of non-listed shares to foreign investors. The approval procedure for such transactions involving state-owned shares was further clarified by the Notice on Issues Concerning the Application Procedures for the Transfer of State-owned Shares in Listed Companies to Foreign Investors and Foreign Investment Enterprises, which was issued in 2004.
A foreign investor wishing to acquire legal person shares or state-owned shares in a listed company must satisfy certain investor qualifications to demonstrate the benefit of its investment. The acquisition is subject to PRC government approval. The purchase price must generally be paid with either convertible foreign currency or renminbi profits generated by other investments in China.
Such shares are subject to a twelve month lockup period commencing from the payment in full of the purchase price. Conversion into an FIE may also be required in connection with such acquisition, although the target will not enjoy the benefits typically available to FIEs.
The A share market is slightly open to foreign financial investors. The Interim Provisions on the Administration of Security and Investment in China by Qualified Foreign Institutional Investors establishes a framework for permitting limited foreign investment in the A share market. Foreign institutional investors that satisfy certain stringent criteria are classified as Qualified Foreign Institutional Investors (“QFII”) and are permitted to make limited A share investments. A QFII is not permitted to hold more than 10% of the outstanding shares of any particular listed company, and the combined holdings of QFIIs in a company cannot exceed 20% of its listed A shares.
The new regulations have introduced a number of changes to the prevailing practice in China. Some of these changes offer greater flexibility, while others close perceived loopholes in current practice.
The new regulations clarify the treatment of foreign investments of less than 25% of the equity in domestic enterprises. Applicable law previously required a minimum foreign investment of 25% of the equity in sino-foreign joint ventures. The regulations did not address the permissibility or handling of smaller investments. Smaller investments were dealt with locally on an ad hoc basis. The new regulations now permit smaller investments. Investments of less than 25%, however, still require adherence to the foreign investment approval procedure, although such invested enterprises shall not be eligible for the benefits typically granted to FIEs. This change has clarified a grey area of current practice.
Asset valuation is now required for all acquisitions of domestic assets, not simply for state-owned assets. The valuation report is to serve as the reference price for the transaction. While the actual purchase price may vary from the valuation, government confirmation of the price may be required if the variance is too large. This requirement may complicate to some transactions.
Chinese nationals have generally been prohibited from holding equity in an FIE. Recent regulations, however, permit individual target shareholders, who have held their shares for a year, to retain their interests following a foreign acquisition subject to government approval. This change will permit greater continuity within target enterprises. This change may also be a first step in providing a basis for employee share incentive schemes within FIEs.
China is beginning to examine market concentration issues. Drafts of a proposed anti-trust law are circulating and it is anticipated that such a law will be adopted in 2004. It is also anticipated that a special anti-trust agency will be established at that time.
In theory, the regulations applicable to the foreign acquisition of domestic enterprises provide for an anti-trust type review in certain circumstances. Pursuant to the regulations when a foreign investor is acquiring a domestic enterprise, as opposed to an FIE, a review may be undertaken if current business turnover in China or market share reaches certain thresholds prior to or after the transaction.
The regulations, however, provide little guidance on the specifics of this review process, and in practice, these provisions have not been implemented. Anti-trust reviews are not expected to commence until after detailed regulations are adopted.
China has made considerable advances in the last several years in developing a regulatory framework for M&A transactions. These regulatory developments have broadened the scope of permissible acquisitions and highlight China’s commitment to honouring its WTO undertakings.
These recent regulatory enactments establish the beginning of a viable framework for M&A transactions in China. Both the range of targets and acquisition methods have been expanded and emerging market practices have been standardised and validated. It can be expected that more detailed implementing regulations filling out the recently enacted general provisions will be issued in future.
China should continue to attract the interest of foreign investors and M&A transactions should become an increasingly viable method of accessing the Chinese market.
Whilst every effort has been made to ensure the accuracy of this publication, it is for general guidance only and should not be treated as a substitute for specific advice.