Leverage Not Taboo
The requirement for a high level of leverage to finance a project is neither unusual nor taboo in China, and there has in the past been no shortage of willing borrowers, lenders and (most importantly) approval authorities keen to execute leveraged transactions.
However, most of this activity has been in the context of transactions generating tangible assets such as new plant and infrastructure. This is now being extended—with the enthusiasm of all concerned—to the consummation of structured financing transactions designed to finance the origination and carrying of financial assets such as loans, rentals and trade receivables. So does a thriving economy continue to expand.
In China, however, the exuberance for leverage has not so far extended to corporate takeovers. It is one thing for the government partially to divest its holdings in state owned enterprises, accompanied by injections of new equity capital into the SOEs to fund capital expansion, in IPOs and strategic investment transactions. It is another thing for the government to acquiesce in the change in control of Chinese companies where the would-be acquirer (particularly if it is a foreign entity) has one of two motives (in the mind of the government): housecleaning or exit. The government would rather have it both ways. The existing personnel and business should be what remains at the end of the day and the acquirer should increase the going-concern value of the company by "reforming" both those people and the business that it acquires1. For these purposes, the word "acquirer" refers to a foreign-organized acquirer of more than 50% of the voting stock of a Chinese company that is (or is the largest shareholder in) a listed2 Chinese company, and "takeover" refers to a transaction which leads to that result.
This article examines, in relation to listed companies: (a) the reasons in favor of at least some types of takeovers, and; (b) the methods by which takeovers can utilize leverage to enhance the acquirer’s incentives. Being an area that has not yet been tested, leveraged takeovers in China present a set of risks which this article briefly analyzes and attempts to quantify.
Takeovers Not Considered Intrinsically Valuable
A takeover for its own sake lacks appeal to the Chinese policy-makers, since no asset is created. Indeed, where the company is state-owned, simply to give the government funds in exchange for control of the company begs (in the view of the government) the twin questions of: (a) how to reform the company, and; (b) how to define the government’s ongoing role in the economy.
Company boards owe a fiduciary duty to their shareholders. There are certain types of company, however, that owe fiduciary duties to other constituencies as well. For example, financial institutions that take Other People’s Money, at least when Other People means the retail public, owe fiduciary duties to depositors, policy-owners, and brokerage and fund investors. In the shiny world of theory, the State as owner of a financial institution has the best interests of all its citizens, including the Other People whose Money such financial institution controls, at heart. But this theory culminates in the concept of financial institution as shadow tax collector.
It creates conflicts between the purely financial motivations of the people whose residual income is placed in financial institutions and the fiscal (or less salutary) motivations of the central and local governments that are the owners of such financial institutions. Although the Guangdong Development Bank ("GDB") transaction could not be approved as a takeover, there is nothing to say that this situation could not change in the future. Indeed, the financial services sector is an area that, a priori, is best run professionally rather than by the state. However, such a development is likely to unfold as an iterative process, as the provision of credit is a highly sensitive industry where: (a) the alternative methods of capital raising, such as bond and stock markets as well as private placements, are still embryonic, and; (b) the need to fund capital expenditures is still critical.
A second area where takeovers may be welcome is for companies in distress (yet, for purposes of leveraged takeovers, have positive book net worth). It is important to bear in mind that the shareholders of the target company will be likely to include as a majority various governmental entities, and that for the foreseeable future, the motivations of such shareholders are not those typically prevalent in Western economies. The conventional wisdom of having a three-pronged arsenal to mitigate the risk of fundamental disagreement with management (proxy battles, derivative suits and the ability to exit positions in the stock market) is not very relevant in China—for the foreseeable future it is these governmental entities that will be left holding the bag for failed management of significant enterprises, whether as stockholders or otherwise. The pool of management talent that understands how to sell goods and services in China is not yet deep enough to support a full-blown market for corporate control. There is little interest, as yet, in having debates about corporate policy play out in the Chinese securities markets. Rather, it is when there is nothing left to debate, as in the case of a chronically unprofitable company, that a takeover begins to make sense, a posteriori.
A third area is street sales. These must be approved, or taken up in a purchase, by a majority of the other shareholders—by a controlling shareholder in a company that is not state-owned, such as street sales of interests in Sino-foreign joint ventures or in privately owned enterprises for purposes of converting to "FIE" status (generally, a tax-favored domestic enterprise with 25% or greater foreign ownership). This has been an active market of late, but because this article is concerned with changes in control involving listed companies, it is not further discussed here3
Perhaps most fundamentally, there may be some industries in which, far from wanting more plant and infrastructure creation, the policy makers would like to see less—i.e. a corporate consolidation and weaning process that is the cauldron out of which national champions in such industries may be born.
Foreign Takeovers Legally Possible
The two leading precedents are the pending acquisitions (not "takeovers") of Guangdong Development Bank ("GDB") and Xugong Group Construction Machinery Co Ltd ("Xugong"). That they are not takeovers should not be disheartening for acquirers. These targets displayed only some and not all of the optimum conditions for permitting a takeover. While they are both companies in need of improved competitiveness, in "bedrock" industries (banking and construction machinery) as a whole that are also in need of improved competitiveness: (a) GDB is in an industry in which conversion to "foreign invested" status (greater than 25% foreign ownership) entails certain legal consequences which the banking regulator (the China Banking Regulatory Commission, or CBRC) would consider ‘prudentially’4 unacceptable, and; (b) Xugong5 is in an industry considered6 (rightly or wrongly) by observers to be sensitive to national security. In other words, these and any other proposed takeovers of companies in industries which do not forbid majority foreign ownership as a matter of law under the post-WTO accession rules may only be stopped at the discretion of the approval authorities.
What a Leveraged Buy-Out ("LBO") by a Foreign Sponsor Might Look Like
We turn to the methods by which it may be possible to enhance the acquirer’s financial incentives through the use of leverage. A high degree of leverage is typically not available on arms length commercially reasonable terms unless the leverage provider is contractually or structurally senior to general unsecured creditors of the owners of the most valuable corporate assets. The challenge of LBOs lies in the fact that the acquirer typically owns only stock and can only own valuable collateral by way of mergers, and absent such mergers, the acquired company and its subsidiaries must approve the grant of security to the leverage provider. We contemplate the following hypothetical situation, which similar in some but not all respects to what is known publicly about the Xugong transaction:
The target is an unlisted PRC incorporated company ("Target") that owns (among other things) a substantial though not necessarily majority stake in another PRC incorporated company ("Listco Sub") that has A shares listed in China, as well as other unlisted subsidiaries in China (collectively, "Target Group"). Target is indirectly majority owned by the government by virtue of the government’s ownership of the majority owner ("Parent") of Target. Target operates in an industry which, post-WTO accession, does not prohibit majority foreign-owned companies. The acquirer is ultimately owned by a highly creditworthy foreign entity that meets the qualifications applicable to foreign strategic investors in listed companies set out in the Strategic Investor Rules, but neither the acquirer nor such foreign entity is, or is affiliated with, a QFII. Neither the acquirer nor the foreign entity has appreciable sales in China. Target Group has steady revenues primarily from domestic sales, and has little financial indebtedness relative to the book value of its assets (or at least would remain solvent after giving effect to indebtedness incurred by Target Group members in connection with the takeover). Target Group has substantial assets comprised of plant, property and equipment, inventory, trade receivables, and/or bank accounts.
Acquirer and Parent agree that acquirer will acquire X% of the fully diluted equity (the "Stock") of Target from Parent for a price of RMB equivalent of $A (the "Acquisition Price"). Under the CSRC’s Administrative Procedures for the Acquisition of Listed Companies (effective September 1, 2006) (the "Offer Rules"), unless an exemption is granted by the CSRC, the maximum interest in a listed company’s "issued shares" that can be acquired (directly, or indirectly by acquisition of the Stock) by negotiated purchase is 30%. Any excess over 30% must be obtained by means of a general or partial (i.e. for 5% or more) tender offer. See Articles 47 and 61.
Alternative Structure A: 80% of the Acquisition Price will be funded by a loan ("Loan") from a bank ("Bank")7 booking through one of its offshore offices, that has a branch (or subsidiary) ("Branch") in China.
Acquirer, foreign entity, Parent, Target Group members, and Bank and Branch enter into a participation agreement ("PA"). The key provision of the PA is the agreement of the parties that: (a) the Acquisition Price is paid to Parent and Parent will hold the Stock "in trust" for the acquirer (which remains the exclusive beneficiary of all indicia of economic ownership including dividends (after all required debt service), voting rights and the right to transfer the Stock); (b) disbursement by Branch, at the instruction of the acquirer, of the proceeds of the Loan (to the Parent) and other drawdowns under a secured credit facility ("Secured Facility") between Branch and Target Group members (to Target Group members) is consideration for the grant of security over the assets and cross-guarantees of the payment obligations of various members of Target Group in favor of Branch; (c) payment to Branch by Target Group members is good discharge, to the extent of such payment, of required debt service on the Loan and other indebtedness under the Secured Facility; (d) there is no recourse to Parent for any obligations under the Secured Facility, except that the Parent indemnifies Branch against any losses suffered as a result of the deliberate violation of covenants8 under the "trust" arrangement, and; (e) the foreign entity agrees to pay Bank the difference between required debt service under the Secured Facility and amounts actually received by Branch from free cash flow of Target Group (as well as after enforcement of rights), unless that difference is due to the deliberate breach of Parent’s obligations under the trust arrangement.
The key role in this transaction is that of Branch. Branch must be willing and able to carry the amount of the exposure under the Secured Facility (a RMB asset) on its books, with or without funding from Bank. There is also a currency mismatch between the Branch’s loan assets and the "investment" in the Branch by Bank in such amount.
Alternative Structure B: 70% of the Acquisition Price is funded by an unsecured USD bridge loan to the acquirer (guaranteed by the foreign entity9) from one or more offshore lenders. This loan is refinanced ("Prepayment") by a dual currency (USD/RMB) loan facility from one or more domestic lenders (the "Secured Facility"), under which Target (as surviving corporation in a merger (the "Merger") by acquirer into Target that marks the termination of the bridge facility and of the effectiveness of the Secured Facility) and other Target Group members may draw, which is cross-guaranteed by all Target Group members, and which is secured by all Target Group assets. The Target draws an amount equal to the Prepayment under the Secured Facility, while other Target Group members draw on the Secured Facility from time to time for working capital needs. Funds might also be available to make payments necessary to cash out certain shareholders of Target Group members as discussed in "CSRC Risks" and "Risks Under Company Law" below, to the extent such cash outs (as conditions precedent to drawdown/release from escrow) are not funded by internal cash.
In Structure B, the foreign entity remains on record as ultimate owner of Target and Listco Sub, and there may be significant upfront cross-border debt service flow (the Prepayment) and the potential for complex inter-creditor negotiations in connection with the Merger (see discussion in "Risks Under Company Law" below). The refinancing and Merger10 are for the purpose of avoiding concerns about using domestic bank funds to acquire Stock, and banking law and corporate benefit concerns if the borrower of the domestic bank funds is a foreign entity that is not a Target Group member. Structure A avoids these potentially troublesome aspects, subject to the risks discussed in the last paragraph of this article.
Risks: The Lenders’ post-drawdown risks in these structures can be summarized as follows:
CSRC Risk: This is the risk that the CSRC do not waive the requirement that acquirer must make a partial or general offer for any part of the shares of Listco Sub indirectly to be acquired that constitutes an excess over 30% of the issued shares. In this event, since acquirer itself has no power to purchase and own A shares in its own name, it would have to "entrust" a party, such as Target, to make the offer and hold the A shares in trust for acquirer.
Risk Arising from Conversion to FIE Status: By virtue of the takeover, Target has (at least under Structure B and probably A as well) become an FIE, a conversion which requires approvals from a host of regulatory bodies—the NDRC, MOC, SASAC, SAIC, SAFE and the Tax Bureau, at either central or local levels depending on the transaction—and while these approvals are generally given so long as the formal requirements for investment and documentation are complied with, the MOC in particular retains discretionary authority to disapprove transactions on various grounds such as national/economic security and harm to competition. However, most of these approvals can be made conditions precedent either to drawdown or to release of funds from escrow, with the exception that 20% of any additional equity contribution to Target in relation to Target’s conversion to FIE status (if acquirer subscribes to an increase in capital of Target) is required before a business license will be issued to the FIE, and certain tax procedures required to permit dividends to flow offshore cannot be finalized until the monies are released to the Target or Parent.
Bankruptcy and Perfection Risk: If a Target Group member becomes insolvent within one year after its grant of security, that grant could be rejected to the extent given for inadequate value, under Article 31 of the Bankruptcy Law, with the result that in relation to the obligations of that Target Group member, the lenders would hold only general unsecured claims. The perfection of security interests in rights and in bank accounts is also uncertain. However, registration is possible at the local notary public in relation to the former (per a ruling of the Ministry of Justice), and the consent of the account debtor (in the case of the former) and acknowledgement of the account bank (in the case of the latter) would pre-empt rival claims of other creditors absent deliberate breach by the account debtor or account bank (in which event a claim would arise against those parties).
Risks Under Company Law: Subject to the possibility of cashing and or merging out dissident shareholders of any given Target Group member security grantor, (A) the use of corporate assets to secure the borrowing by upstream entities (as opposed to own borrowings) must be approved by a majority11 of shareholders (exclusive of shareholders that are the borrowers) present at a shareholder meeting of each Target Group member providing collateral. These approvals should, if possible, be made conditions precedent to drawdown; and (B) for the Merger, in addition to approval of two thirds of the shareholders present at a shareholder meeting, the non-objection (within the later of 30 days after actual notice or 45 days after publication in a newspaper) of creditors of Target is a condition to the effectiveness of the Merger. Objecting creditors have a right to prepayment or equal and ratable security. A cash-out could be funded with internal cash as a condition precedent to drawdown or through draws on the Secured Facility as a condition subsequent. Whether or not a cash-out is necessary, the all-in costs of the financing would rise, either to pay the guaranteeing companies some consideration (e.g. guarantee fee) or to increase the amount of group stock being purchased.
Risks Under Banking Law: This is the risk that the Secured Facility in Structure B would be recharacterized as a loan extended to finance the acquisition of shares, which is prohibited.
Liquidity, Currency and Political Risks Relating to Branch Investment: This is exacerbated by the recent State Council Decree No. 478 Administrative Provisions Applicable to Foreign Funded Banks (effective December 11, 2006), which requires branches of foreign banks wishing to engage in either credit card or retail RMB-denominated business to re-incorporate in China. Whereas in the past Bank and Branch were one accounting entity (regardless of the Bank’s internal policies on quantifying the political/inconvertibility risk of its capital in China and regardless of Chinese banking laws requiring each branch of a foreign bank to adhere to capital requirements on a standalone basis), banks that wish to engage in such businesses can no longer be so. Bank’s overall cost of capital will increase (if it intends to engage in such businesses) compared to what it would have cost to maintain a similar asset in the branch prior to the effectiveness of the new law. Presumably this will be charged through in the interest rate on the Secured Facility.
Risk that Entrustment Arrangements not Enforceable Against Entrusted Party: Generally, under the PRC Contract Law, a contract (including its remedial provisions) will be enforceable against the obligor thereunder so long as adequate consideration has been given for the obligation and the performance of that obligation does not violate law. Since the Parent received the proceeds of the Loan, adequate consideration for its obligations under the PA would have been given. The question is whether the acquisition, financed by domestic bank loans, of control of the Target and, indirectly, Listco Sub and other Target Group members, by a foreign entity would be considered a violation of PRC law. Given the hypothesis of non-prohibition under the Catalogue of Foreign Investment, and the formal features of Structure A, in which it is not the acquirer that is the actual borrower of domestic bank funds but other parties, such an argument by Parent and Target seeking to abrogate the trust arrangement, either in a distress situation or due to fraud/willful breach, should not succeed12 However, the risks of fraudulent preference, failure to close necessary post-drawdown corporate approvals (as for cash outs of dissidents or post-drawdown mergers), or failure of the foreign invested enterprise to obtain required licenses and approval for continued operation could be further mitigated through an escrow of the Acquisition Price—unlike the case of the LBO of a public company, which would be mechanically impossible to unwind, it would not be mechanically difficult to unwind the escrow of Parent’s funds.
As can be seen from this brief analysis, potential structures exist for leveraged takeovers within China. Associated with these is a set of risks that, in the main, are both identifiable and quantifiable and which can be addressed in the deal structure. These should not in this writer’s view, in principle, discourage those considering a more fundamental level of participation in the mainland economy through the use of LBOs.
The author gratefully acknowledges the assistance of Zhao Ying and Li Yongyi. Ying is a lawyer in White & Case’s Beijing office and Yongyi will join White & Case’s New York office in September.
This White & Case Client Note is prepared for the general information of our clients and other interested persons. This Client Note is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, and the fact that it based on draft legislation that may or may not be enacted, this Client Note is not and should not be regarded as legal advice.
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© 2007 White & Case LLP
Strategic investors in domestically listed companies are subject to the three year lockup provisions of the "Administration of Strategic Investment in Listed Companies by Foreign Investors Procedures" promulgated by five ministries and effective January 31, 2006 (the "Strategic Investor Rules"). With the implementation of conversion of those non-tradable shares held by the government in Chinese companies into tradable shares (the so-called share reform), virtually all critical Chinese industry will be represented by listed companies. The recent "Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors" effective September 8, 2006 promulgated by six ministries sets out the parameters of CSRC and Ministry of Commerce review of transactions involving the use of cash or foreign stock as currency by which foreign investors (such as tax haven special purpose companies that will issue interim debt and equity securities and/or list abroad) acquire interests in domestic enterprises. China retains, post-WTO accession, the right to impose "prudential" measures but not access restrictions in the banking industry. In order to conduct RMB retail business the banking regulators require three years of business and two consecutive years of profitability in China (in the case of foreign funded financial institutions) and also deposit insurance. Mainly due to the inconvertibility of the RMB, the Chinese authorities regard their ability to measure profitability and eligibility for fiscally subsidized insurance, as well as capital adequacy, as prudentially meaningful only in relation to Chinese-incorporated entities, rather than in relation to worldwide bank branch networks. Thus, a bank that were to become a foreign funded financial institution (by definition a bank with over 25% foreign ownership) would become subject to prudential capital requirements that would be prohibitive unless it were already thinly capitalized due, for instance, to financial distress. This position is not uncontroversial as a matter of WTO interpretation, although Malaysia is cited as a precedent. Xugong was, prior to the reorganization of its assets into "bad" parent and "good" target, heavily indebted, with sluggish sales growth but significant assets such as land and plant carried at book value, and in a dominant position in a weak domestic market. One argument against the proposed takeover was that Xugong was (among other things) a contractor to the PRC military. Bank may fund itself through sub-participations and/or credit-linked obligations. These include agreements as to voting of the Stock, adhering to instructions from the acquirer with respect to corporate policy, dividend payments, and the use of free cash flow within Target Group to procure the payment of debt service under the Secured Facility to Branch. The banks are likely to require contractually or structurally subordinated debt and equity to be issued by the acquirer or its parent to finance the balance of the Acquisition Price. The tax consequences of the Merger would need to be examined to ensure that they are tax beneficial or at least tax neutral. The requirement is two thirds in the case of listed companies. Article 50 of the Offer Rules requires the acquirer to submit to PRC jurisdiction in connection with an acquisition of Listco Sub. Parent would agree to waive any sovereign immunity rights it might enjoy.
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