On August 8, 2006, the Ministry of Commerce ("MOFCOM"), joined by the State-owned Assets Supervision and Administration Commission of the State Council, State Administration of Taxation, State Administration for Industry and Commerce, China Securities Regulatory Commission ("CSRC") and State Administration of Foreign Exchange, amended and released the Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises (the "M&A Rules"). The M&A Rules, which take effect September 8, 2006, supersede the existing M&A rules in China that were in place since April 12, 2003 — the Interim Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises ("Interim Provisions").
The M&A Rules represent an important step in the further development of China’s regulation of the foreign acquisition of China-based companies. In addition to the four agencies that promulgated the earlier rules, both SASAC and the CSRC joined in issuing the M&A Rules. MOFCOM will continue to be at the center of regulatory activity in this area but will now be cooperating with an even broader range of government agencies than before. It is clear from the M&A Rules that China’s key government agencies are increasing their attention to M&A activities and can be expected to be even more active in monitoring and regulating foreign investment in China through these type of transactions.
The new M&A Rules are important for the following reasons:
- Replace the existing M&A rules that have been applicable to China M&A for the past 3 years;
- Signify greater government attention to cross-border M&A activities;
- Confirm MOFCOM as key regulator for anti-trust issues related to M&A;
- Require MOFCOM approval of a range of M&A transactions, while also requiring MOFCOM to coordinate with other ministries during the approval process;
- Establish CSRC approval procedure for IPOs involving offshore SPVs that hold China assets;
- Permit the use of foreign corporation securities to acquire China companies;
- Establish reporting requirements for acquisition of control by foreigners of companies in key industries; and
- Reinforce ability of government to monitor and prohibit foreign control transactions in key industries.
The M&A Rules grant MOFCOM express authority in anti-trust and M&A review and may significantly affect the means by which offshore-onshore restructurings are undertaken in China in connection with offshore private equity and venture capital financings, mergers and acquisitions, and initial public offerings. The M&A Rules provide the basic framework in the People's Republic of China ("PRC") for the approval and registration of acquisitions of domestic enterprises by foreign investors. Other regulations will be applicable depending on the identities and industry sector(s) of the parties to the acquisition, whether foreign-invested enterprises ("FIEs"), state-owned enterprises, or publicly listed companies.
We have seen a rapid development of M&A activity in China in the last several years, which has given rise to many issues not effectively addressed by the existing M&A rules. It is notable that the M&A Rules were amended and agreed upon by six government agencies within a relatively brief time period (with MOFCOM playing a key coordinating role) whereas the Interim Provisions had been issued by only four government agencies. During this time there has been a significant amount of media coverage of foreign acquisitions of domestic enterprises, and a resulting vigorous public discussion of whether the government should intensify restrictions on foreign-related M&A activity in China - particularly in respect of companies operating in certain sensitive areas. This has been accompanied by further concerns focused on whether the government should impose greater control on activities involving "small red-chip", roundtrip investments and M&A among companies under common control. While the M&A Rules address these issues, it is expected that M&A activity in the near future will require significant case-by-case guidance from MOFCOM and other government authorities as appropriate.
The M&A Rules have expanded from twenty-six articles in the original 2003 version to sixty-one articles organized in five chapters. Highlights of the M&A Rules include the following:
Regulation of Offshore Special Purpose Vehicles. An offshore special purpose vehicle ("SPV") is defined under the M&A Rules as an offshore entity directly or indirectly controlled by PRC individuals or enterprises with the objective of an overseas listing, the main assets of which are its rights and interests in an affiliated domestic PRC enterprise.
Key elements on share-for-share exchanges ("Share Swaps") involving private SPV shares include:
- MOFCOM approval is required before the PRC individuals or companies establish an SPV;
- In addition, when an SPV engages in a Share Swap, either when a shareholder of the SPV uses its shares in the SPV or when the SPV itself issues new shares as consideration to acquire a domestic company, it must obtain an initial approval reply from MOFCOM;
- The domestic company must then seek the approval of the CSRC for the overseas listing of the SPV;
- Upon the approval of the CSRC, the domestic company must return to MOFCOM to apply for a FIE approval certificate with the annotation "valid for one year from the date of issuance of the business license", indicating that the conversion of the domestic company into an FIE has been approved;
- 30 days after the listing, the FIE must report to MOFCOM on the plan to return the proceeds of the offshore offering to the PRC; and
- If the SPV does not complete an overseas listing within one year from the issuance of the business license to the FIE, or if the FIE fails to report to MOFCOM within 30 days of the SPV’s overseas listing, the Share Swap transaction would be unwound and the FIE converted back into a domestic company.
While we understand that the provisions on SPV Share Swaps are intended to clarify issues, they also raise questions that will need to be further clarified by the authorities, such as whether a straight cash acquisition of shares of an offshore company followed by a listing of the offshore company would be subject to the same approval requirements, and whether all listings by any offshore entity with Chinese businesses are subject to approval.
Share Swaps by Foreign Acquirers now Permitted.A critical development in the M&A Rules is the introduction of Share Swaps as a payment method for the acquisition of a Chinese company. Foreign companies may now consider using their own shares to acquire a domestic company in the PRC rather than solely cash.
Key elements on Share Swaps include:
- shares must be publicly traded and from a company registered in a foreign jurisdiction with a well-developed corporate legal system;
- foreign acquirers must engage a PRC registered M&A consultant, which will conduct due diligence on the foreign shares and issue a consulting report for review and examination by the approval authorities, and
- an acquirer must pre-execute certain documents which would be used to roll-back the transaction and re-implement the original share structure of the domestic company if certain conditions - including the Share Swap - are not completed.
Anti-Trust and Related Issues.The M&A Rules heighten the ability of the government to monitor and regulate M&A activity that may result in either concentration of control of industries or control of companies in industries that are considered "key" industries in the PRC economy.
Trade Protection Concerns.The new MOFCOM reporting provisions, combined with the existing anti-trust provisions, raise concerns about an expansion of Chinese trade protection. As widely reported in the media, various acquisitions are currently stalled and awaiting regulatory approval such as the Schaeffler Group’s bid to buy Luoyang Bearing Group, one of China's three largest bearing producers. In July Hong Kong-listed Shanghai Industrial Holdings Ltd. abandoned its bid to buy a 21 percent stake in Lianhua Supermarket Holdings Co. Ltd. after it failed to obtain statutory approval. At this time it is unclear how the PRC government will apply the M&A Rules, but it will be important to monitor them in practice to evaluate their impact on any proposed transaction.
National Economic Security Concerns.The M&A Rules stress the necessity of protecting national economic security in the context of foreign acquisitions of domestic enterprises. Foreign investors must comply with MOFCOM reporting requirements in connection with acquisitions of domestic targets engaged in key industrial sectors, which affect (or may affect) the security of the "national economy", or in connection with acquisitions of domestic targets holding well-known trademarks or traditional brands in China. If the parties fail to declare such an acquisition which causes, or may cause, significant impact on national economic security, MOFCOM has the discretion to join with other relevant ministries to order the termination of the transaction, or to take such other measures as are deemed necessary to mitigate the adverse impact.
Restrictions on Round-tripping Investments.The M&A Rules include new provisions geared at deterring "false" foreign investment. These provisions include:
- Prohibition on using trusts and other arrangements in the control of offshore or domestic entities. If any of the parties to an M&A transaction are under common control by the same controlling entities, the ultimate controlling parties must be disclosed to the approval authorities, together with an explanation of the purpose of the M&A transaction, and whether the appraisal for the acquisition was conducted on an arm’s length basis.
- Requirement that if a PRC entity establishes an offshore company for the purpose of acquiring a related domestic company, the post-acquisition company will not enjoy FIE treatment unless (i) foreign investors - other than the PRC-controlled entity - hold 25% or more of the post-acquisition company, or (ii) the offshore company invests additional capital accounting for at least 25% of the post-acquisition company’s total capital.
Conformance with Other Laws. The M&A Rules emphasize that a basic principle of any acquisition activity is compliance with the regulations governing acquisitions of domestic entities which have state-owned assets. The M&A Rules also incorporate certain changes to conform with the recently amended Company Law. The most substantive of these changes is the requirement that if foreign investors will be investing additional registered capital in a domestic company, no less than 20% of that increased registered capital must be contributed upon registration of the new business license. This effectively requires that any increase in registered capital must include a cash component of no less than 20%. The M&A Rules also provide that the parties to the M&A transaction shall pay the PRC taxes in accordance with the PRC tax law and accept the supervision of the PRC tax authority.
The M&A Rules significantly revise China’s M&A framework governing onshore-offshore restructurings and how foreign investors can acquire domestic enterprises, and also signal the PRC government's greater focus on issues related to such cross-border transactions. We anticipate that application of the M&A Rules will be subject to significant administrative interpretation, and it will be important to closely monitor how MOFCOM and other ministries apply them.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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