To promote the expansion of PRC companies domestically and internationally by mergers and acquisitions in the current global economic crisis, the China Banking Regulatory Commission has promulgated the "Guidelines on Risk Management for Loans extended by Commercial Banks for Mergers and Acquisitions" (the "Guidelines") on 6 December 2008.

Previously, pursuant to Article 20(3) of the PRC General Lending Rules (the "Lending Rules"), any bank loan for the investment of any beneficial interest in shares or equity is prohibited unless otherwise specified by law. The Guidelines remove the prohibition under the Lending Rules and PRC banks may now extend loan to borrowers to finance or fund payment of the price of a merger and acquisition transaction ("M&A Loan"). M&A Loans refer to those loans extended to PRC purchasers or their subsidiaries and may include loans for cross border acquisitions but do not include loans made to financial investors.

Definition of "merger and acquisition transaction"

According to Article 3 of the Guidelines, "merger and acquisition transaction" ("M&A Transaction") is defined as a transaction in which a PRC company merges with another company and/or acquires the actual controlling interest of another target company as a going concern either by way of acquiring the existing shareholding, subscribing for new shares, assets acquisition or assumption of loans.

It is still not possible to utilize the M&A Loan to set up new companies or greenfield investments or in a M&A transaction of a non-controlled nature. The Guidelines do not place any limitation on the place of incorporation of the target company. As stated above, subject to compliance with the relevant foreign exchange regulations, PRC companies may use the M&A Loan to acquire the controlling shareholding of an overseas company.

Under the Guidelines, a bank may only make M&A Loans if :-

(a) the adequacy ratio of its loan loss reserves is not less than 100%;

(b) its capital adequacy ratio must not be less than 10%;

(c) the balance of its general reserves shall not be less than 1% of the balance of its loans.

Risk management obligations of the bank

For the purpose of risk management, the Guidelines impose the following requirements on banks in extending any M&A Loan to finance a M&A Transaction :-

(a) The total amount of outstanding M&A Loans extended by a bank shall not exceed 50% of its core net capital;

(b) The total amount of outstanding M&A Loan of a single borrower shall not exceed 5% of its core net capital;

(c) The amount of M&A loan shall not account for more than 50% of the total funding used for a single M&A transaction; 

(d) The term of the M&A Loan shall not exceed 5 years;

(e) The borrower shall provide sufficient security to cover the bank's lending risk.

The Guidelines also require banks to adopt more stringent requirements towards securities to be provided by the borrowers for M&A Loans than in the case of other types of lending.

In addition, for the purpose of risk assessment, the Guidelines also require the bank to form a special team to conduct the following investigations, analyses and assessments and make a written report before extending any M&A Loan :-

(a) Strategic risk including the industry prospect, market structure, business strategy, management team, corporate culture and shareholders' support;

(b) Legal and compliance risk;

(c) Merger and integration risk;

(d) Operational and finance risk;

(e) Financial model and forecast of the financial data of the purchaser and the target company and indication of the finance leverage and ability of repayment; and

(f) Sufficiency of the source of funds of the borrower for repayment.

Whilst the Guidelines aim to encourage PRC companies to consolidate or expand domestically or overseas, it is too early to comment on the practical effect of the Guidelines considering the onerous obligations on the bank for the evaluation and risk management of M&A Loans.

If you have any question about the above Guidelines or other issues on foreign direct investments, joint ventures, mergers and acquisitions in Mainland China, experienced lawyers in our China Business Department will be happy to assist you.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.