On August 8, 2006, six PRC ministries jointly promulgated a set of far-reaching rules that have changed the landscape for foreign mergers and acquisitions, offshore listings of Chinese companies, and the restructurings of PRC companies, which commonly precede foreign investment of venture capital and private equity.1 The Rules became effective as of September 8, 2006.
The new Rules supersede the 2003 Interim Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises promulgated by the PRC Ministry of Commerce (MOFCOM), and are intended to comprehensively regulate foreign investment in China as well as Chinese companies’ access to international capital markets. The Rules also represent an unusual consensus among six different government agencies in the PRC, which in the past have often issued incompatible and sometimes contradictory rules in this area. The Ministry of Commerce has emerged as the lead agency for foreign M&A, but the Rules also give a new and prominent role to the China Securities Regulatory Commission (CSRC) in the case of offshore listings of Chinese companies.
MOFCOM is Lead Agency; Approvals from Beijing Will Sometimes be Required
Under the new Rules, MOFCOM is designated as the lead agency for all foreign M&A activities in China. The new Rules cover all acquisitions of domestic companies or assets by foreign investors, including overseas companies under the de facto control of PRC persons or entities. MOFCOM approval from Beijing will be required if a "key industry" is involved, where the acquisition might have an impact on "national economic security" or where the deal will result in a transfer of actual control of a domestic enterprise that owns a well-known trademark or historic Chinese brand name.
The requirement for approvals by MOFCOM in Beijing is certainly intended to centralize the foreign M&A approval process, and reduce the inconsistencies that have resulted from the previous system of local approvals. However, this centralization will put a strain on MOFCOM’s resources in Beijing, and may cause additional delays in moving transactions through the approval process. It also will reduce the ability of parties to make legitimate use of long-standing relationships with local government agencies.
In handling transactions covered by the new Rules, MOFCOM will coordinate and work with the other five agencies which jointly promulgated the Rules: the State-owned Assets Supervision and Administration Commission of the State Council (SASAC), the State Administration of Taxation (SAT), the State Administration for Industry and Commerce (SAIC), the China Securities Regulatory Commission (CSRC), and the State Administration of Foreign Exchange (SAFE).
Equity Swaps Permitted
For the first time, the Rules explicitly permit the use of the equity of a foreign company to be used to acquire the equity of a PRC target: a "stock-for-stock" acquisition. In the past, there was no specific statutory guidance on using equity for acquisitions in China, but applications to do so were generally rejected. The use of stock is now permitted, subject to new and detailed requirements, including:
- Except for special purpose vehicles (SPVs),2 only companies listed on recognized stock exchanges may use equity for acquisitions in China; OTCBB is specifically not a "recognized stock exchange" for purposes of this section of the Rules (Arts. 28-29).
- The foreign acquirer must also meet a variety of other requirements, including that its trading price must have been "stable" in the most recent year (Arts. 28-29).
- Approval from MOFCOM Beijing is required for all acquisitions in which equity is used as consideration (Art. 32).
- Higher leverage is permitted for companies acquired through stock swaps—the debt to registered capital ratio can be as high as 70% for companies with a total investment of only US$12 million (formerly $30 million) (Arts. 19-20).
- A valuation of the assets or equities to be sold, conducted by a PRC "asset appraisal institution," will be required in all cases (Art. 14); the parties can select any "asset appraisal institution established according to the law in China," and the appraisal is to be conducted according to an "internationally-accepted appraisal method." Transferring assets overseas "in disguise" by setting a transaction price "obviously lower" than the appraisal result is prohibited.
- A report from an "acquisition consultant" is required for all acquisitions in which stock is used as consideration; this is a new function created by the 2006 Rules (Arts. 30-31). The acquisition consultant will "conduct due diligence on the "truthfulness of the application documents, the financial status of the overseas company and whether the acquisition satisfies the requirements of Articles 14 (no sale obviously lower than appraised value), 28 and 29 (requirements applicable to overseas companies)."
- A complex system of provisional approvals is established, involving MOFCOM, SAIC, and SAFE, and SASAC if State-owned companies or assets are involved (Arts. 32-35).
- If the transaction does not complete (i.e., the equity is not transferred) within six months of the issuance of the business license, the transaction will be unwound (Art. 36).
There are new procedures applicable to the treatment of a target’s debts and liabilities in asset acquisitions. The general rule follows the familiar approach: in an equity deal, the target retains its claims and debts but is owned in whole or in part by the foreign investor after the transaction, and in an asset deal the claims and debts are left behind (Art. 13).
There are two important caveats, however. First, if the parties to either an equity acquisition or asset acquisition enter into a separate agreement as to the target’s claims and debts, it must not "harm the interests of any third party and the public interest," and must be submitted to the examination and approval authority. Second, in all asset deals, the domestic enterprise selling assets must issue notice to creditors and publish an announcement in a nationally-distributed provincial or higher-level newspaper; this must be done at least fifteen days before investor submits the application documents to the examination and approval authority (Art. 13).
There are new restrictions on "round-trip investments:" i.e., transferring ownership of a PRC company offshore so that the domestic operations obtain the benefits of treatment as a foreign-invested entity (FIE). All such restructurings require at least 25% new foreign money before the PRC entity can enjoy the benefits of FIE status; MOFCOM approval at the national level will be required.
Where parties to an acquisition are related—including where the control is only de facto—the parties must "provide an explanation on the purpose of the acquisition and whether the appraisal result is consistent with fair market value." Avoiding this requirement by using trusts, nominees, or other means is prohibited (Art. 15).
New Rules on Special Purpose Vehicles
There are new rules governing the establishment and use of special purpose vehicles (SPVs) as a means to achieve the public listing of PRC companies (Arts. 39-49):
- MOFCOM approvals at the national level will be required for all SPV restructurings (Art. 42).
- A valuation, including a report by a PRC "acquisition consultant" will be required for the SPV restructuring (Art. 44).
- There is a complex system of provisional approvals from MOFCOM, SAIC, and SAFE (Arts. 44-47).
- CSRC approval will be required for any direct or indirect offshore listing of an SPV (Art. 40).
- If the listing does not occur within one year, or if the parties fail to complete the necessary reports to the authorities after a listing, the entire transaction will be unwound (Art. 48).
Significantly, proceeds of the offshore listing do not have to be repatriated immediately, but a repatriation plan must be filed with SAFE and must be followed (Art. 48).
Transactions by or With Existing Foreign-Invested Entities
The new Rules apply to acquisitions in China by foreign-invested "companies with an investment nature." Thus transactions involving new foreign investment into existing FIEs—either outright purchase or by increase of registered capital—will be governed in the first instance by the current laws and regulations on foreign-invested enterprises, and then by the new M&A Rules. Transactions by an FIE in China will be governed by provisions on mergers and divisions of foreign-invested enterprises in China and on domestic investment by FIEs, and then by the new M&A Rules. Finally, conversion by a foreign investor of a limited liability company to a company limited by shares will be governed by the provisions on the establishment of foreign-invested companies limited by shares, and then by the new M&A Rules. (Art. 55.)
Complex Approval Process
The new Rules set out a detailed, complex, multiagency approval process for the various types of transactions covered in the regulations. In many cases, conditional approvals from one agency are required, which are used to obtain approvals from another agency, and which must thereafter be converted to unconditional approvals. In the case of equity swaps and offshore listings, the approvals have a drop-dead provision—if the transaction is not completed within specified time periods, the entire deal will be unwound.
New Anti-Competition Rules
The 2006 Rules also contain the long-awaited regulations concerning anti-competition review and regulation. The new Rules require antitrust clearance from MOFCOM and SAIC in Beijing in the following cases (Arts. 50-54):
- "Large" transactions, wherein:
- A party has more than RMB 1.5 billion in Chinese sales during the current year;
- The foreign investor acquires more than ten companies in a "related industry" in China within one year;
- A party controls 20% of the relevant Chinese market; or
- As a result of the transaction, a party controls 25% of the relevant Chinese market.
- Offshore transactions, wherein:
- A foreign party owns more than RMB 3 billion (US$ 380 million) of assets in China;
- A foreign party has RMB 1.5 billion (US$ 190 million) in Chinese sales during the current year;
- A foreign party or its affiliates controls 25% of the Chinese market; or
- As a result of the transaction, a foreign party owns shares directly or indirectly in fifteen foreign-invested enterprises in a "related industry."
Implementing Regulations Expected
The new Rules provide clarification in a number of areas wherein the government’s policies have not been clear, including with regard to the use of equity as consideration in a Sino-foreign M&A transaction. They also clear up uncertainties relating to anti-competition review, and the approval process for offshore listings of Chinese companies. At the same time, the new Rules set out complicated, multiagency review processes for different transactions, and in many cases are not clear as to the criteria that will be used in the review and approval process.
Practitioners are busy studying the Rules, talking to the government agencies involved, and designing structures to make compliance with the new Rules easier.
1. Officially, the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, promulgated jointly by the Ministry of Commerce, 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, and State Administration of Foreign Exchange, promulgated on August 8, 2006 and effective as of September 8, 2006 (the "Rules" or the "2006 Rules").
2. Companies formed offshore for the purpose of accomplishing the offshore listing of Chinese assets (see "New Rules on Special Purpose Vehicles").
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