China remains an increasingly important and popular destination for international investment. For a foreign investor looking to establish a manufacturing base in China or tap its booming domestic market, a merger or acquisition ("M&A") may offer a speedy viable alternative to green field investment. Whether an investor is looking to establish a presence in China or expand an existing one, an M&A approach may be an efficient option. As the PRC government is actively selling off state-owned assets and domestic companies are seeking to partner abroad, there are plenty of opportunities and targets available.
M&A is accounting for an increasing percentage of the foreign direct investment ("FDI") flowing into China, as many investors are favouring acquisitions over constructing new facilities to speed their entry into the market. The M&A method is now a viable market entry mechanism.
This article offers a broad overview on the current status of M&A practice in China, particularly examining the recently amended regulatory framework, structure options and target types.
Regulating M&A Transactions
PRC government agencies play a major role in foreign-related M&A transactions. Government involvement in M&A transactions is far more extensive than is typical in other jurisdictions. PRC government agencies do not merely act as competition regulators. They play a broader role, substantively reviewing and approving deal-specific arrangements. Their concerns are not limited to the competitive consequences and formalities of a transaction; they will often have social concerns unrelated to the economics of the transaction. Pervasive approval requirements are a distinctive feature of M&A transactions in China.
The required discretionary approvals are not mere formalities and may take considerable effort to obtain. Understanding the regulatory framework and the government's role in the acquisition process is important to successfully concluding transactions in China.
Key PRC Government Agencies
Several government agencies play key roles in M&A transactions. The agency with the most important role is the Ministry of Commerce ("MOFCOM"), which has the primary responsibility for supervising foreign-related M&A transactions. It will be involved in all M&A transactions.
Other important agencies include the National Development and Reform Commission (NDRC) and the State-owned Assets Supervision and Administration Commission (SASAC), which will be heavily involved in transactions involving state-owned assets. The China Securities Regulatory Commission (CSRC) supervises transactions involving listed companies.
Industry-specific and specialized administrative agencies may also be involved, depending on the targeted industry sector and the nature of the transaction. Industry specific approvals are often required. For example, the approval of the China Banking Regulatory Commission is required for bank acquisitions.
The Regulation of Foreign Investment in the PRC
Foreign-related M&A transactions are subject to the general regulatory framework applicable to foreign investment in China. A foreign company may not directly operate a business in China. It must do so through one of four types of foreign investment enterprise ("FIE"): Sino-foreign equity joint ventures, Sino-foreign cooperative joint ventures, wholly foreign-owned enterprises and foreign investment enterprises limited by shares. Each type of FIE has its own distinctive features, but all are generally limited liabilities companies with limited authorized business scopes and limited terms of existence. FIEs with at least 25% foreign investment are eligible to benefit from certain preferential tax policies.
Investment projects are classified by industry sector in the Catalogue for the Guidance of Foreign Investment as "encouraged." "permitted," "restricted" or "prohibited." This project classification impacts both the investment approval process and the permissible level of foreign equity holding. Majority Chinese equity may be required in some restricted sector transactions, while wholly foreign-owned enterprises may be prohibited in others.
A preliminary step in any M&A transaction is to confirm the target's industry sector classification. Recent regulatory amendments have confirmed the controlling nature of the catalogue, which is amended from time to time.
There is a particular regulatory framework applicable to M&A transactions in China. This framework, which developed in a piecemeal fashion over the past several years, underwent a clarifying overhaul in 2006. Under China's civil law system, even basic types of business transaction may be subject to extensive regulation and required authorizations.
The regulatory framework establishes a basis for using conventional acquisition methods to acquire most types of enterprise. Foreign investors are permitted to make asset or equity acquisitions of FIEs, domestic enterprises, state-owned enterprises and listed companies. Most types of enterprise are now permissible targets, but distinct regulatory regimes are applicable to each type of acquisition. Such entity differentiated legal treatment remains fairly common in China.
In addition to defining permissible targets and acquisition structures, the M&A regulations substantially restrict deal terms. They mandate required investor qualifications and identify the applicable approval process. The regulations restrict the permissible types of consideration and payment schedules, and impose valuation requirements that may impact pricing. Many practices common in other jurisdictions are restricted in China.
The specific approvals required for an M&A transaction will depend on the deal structure, the target type and the transaction value. The 2006 amendments largely confirm that the general foreign investment approval authorizations will apply to M&A transactions.
In general, transactions involving encouraged or permitted sector targets with a total investment amount of US$100 million or more will require a national level approval, while such projects under US$100 million can generally be approved locally. Restricted projects with a total investment amount of US$50 million or more require a national level approval, while smaller projects may be approved locally. The amended rules, however, impose national level reporting and approval requirements for certain exceptional transactions, including connected party offshore restructurings and the use of share consideration.
There may also be exceptions to the general rules depending on the particular nature of the target. Approval requirements under specialized regulations, such as those applicable to bank acquisitions, take precedence over the general requirements. The specialized approval requirements are always more stringent.
Structuring The Transaction
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 recognized under PRC law.
The preferred acquisition method, as in other jurisdictions, 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 or the target. 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 onshore acquisition. PRC law also permits existing FIEs to make equity acquisitions if certain conditions are satisfied.
Indirect Equity Acquisitions
An indirect offshore acquisition is possible when the ultimate target is an offshore company's equity interest in an FIE. In an indirect offshore acquisition, the foreign investor acquires the equity of the FIE's offshore investor. This is generally the preferred acquisition method, when the target equity is held by a special purpose vehicle ("SPV") without other assets. Typically, PRC government approvals are not required for such acquisitions, since the FIE's registered equity holder does not change. This form of transaction does not trigger the statutory pre-emptive rights of any other investors. Such a transaction may generally be handled as a typical share acquisition without implicating PRC legal issues.
This acquisition structure is also popular for early stage venture capital investments, pursuant to which Chinese entrepreneurs restructure their domestic enterprise into an FIE owned by an offshore holding company that will allow foreign investment at the offshore level. This structure facilitates the eventual exit of the venture capital investors and offers them a wider variety of investment instruments (preferred shares, convertible debt, etc.) than is typically available in China. These offshore restructurings, however, require PRC approvals and registrations. Such restructured entities are not entitled to FIE benefits without the injection of additional foreign capital. As a result of the 2006 amendments, MOFCOM approval is now required in connection with such related party restructurings, and the listing of such offshore vehicles, a popular exit mechanism, is now subject to CSRC approval.
Direct Equity Acquisitions
In a direct onshore equity 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 from the target through a subscription for new equity. A direct equity acquisition requires the discretionary approval of the Chinese approval authorities. Any other investors will have a statutory pre-emptive right to acquire the interest being transferred.
If a foreign investor is acquiring the equity of a purely domestic enterprise, then the conversion of the enterprise into an FIE will be required, and the approval process for the establishment of an FIE would be applicable. In such case, the legal nature of the target would change and the regulations governing the operations of FIEs would become applicable to the target. The impact of the change in operating rules should be considered when assessing the transaction. The unanimous approval of all shareholders of the target is required to transform the target into an FIE.
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. Consequently, there 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.
A PRC acquisition vehicle is typically established simultaneously with the acquisition to permit the operation of the assets. Considerable government liaison work may be necessary for this type of transaction. Creditors' notification is sometimes required. Worker settlement arrangements will be required and examined in the approval process. In some cases, formal consultation with the target's workers may be required. While the worker settlement issues are typically 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 any of 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 (amended 2001) provide a basis for merging FIEs and domestic enterprises and provide for several different merger structures. 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.
Mergers are subject to a multi-step approval process with preliminary approvals required from both the surviving and the dissolving entities' approval authorities and a final approval required from the surviving entity's approval authority. They are typically time consuming transactions. Mergers are more commonly used to rationalize organizations after acquisitions than as the primary acquisition method.
The range of permissible targets has expanded significantly since the commencement of M&A activity in China. There is now considerable regulatory guidance on acquisitions involving FIEs, domestic companies, state-owned enterprises and listed companies.
Acquisition Of Domestic Companies
M&A transactions involving domestic targets are sanctioned under PRC law. The standardized regulatory framework applicable to M&A transactions involving foreign investors underwent significant amendment with the Provisions on the Acquisition of Domestic Enterprises for Foreign Investors (2006) , which repealed the prior regulations and provides the primary guidance on the acquisition of domestic equity or assets by foreign investors. The regulation sets out the key acquisition procedures and the rules on the use of share consideration and offshore restructurings. Older regulations apply to the acquisitions of FIEs.
The regulations map out the approval procedures for this type of acquisition. The investments resulting from such transactions must comply with China's industrial policies for foreign investment. An acquisition cannot be used to circumvent licensing or industry sector restrictions.
Acquisition of State-Owned Companies
The acquisition of non-listed state-owned enterprises is also subject to express regulations. The Interim Provisions on the Utilization of Foreign Investment to Restructure State-owned Enterprises (2003) establishes a framework for foreign acquisitions of state-owned enterprises and their transfor- mation 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 acquisition application requires SASAC approval. The resolution of employment related issues is an important aspect of the transaction. The target must then handle approval procedures related to the establishment of an FIE.
In certain circumstances, the transaction may need to be handled through a regional equity exchange for transferring state-owned assets. In such cases, the transaction must take place through a registered broker at the exchange and may require open bidding for the assets or equity. Such transactions, however, can often be arranged without other bidders and SASAC exemptions can often be obtained.
Listed Company Acquisitions
Foreign investment in listed companies has traditionally taken the form of negotiated minority stakes for the purpose of developing a strategic relationship rather than seeking operating control. The capital structure of PRC listed companies has generally consisted of a minority of tradeable listed shares and a majority of non-tradeable state-owned and legal person shares. There are two main classes of domestically listed shares: A shares for domestic investors and B shares for foreign investors. The government is currently completing a share reform program pursuant to which the non-tradeable shares (including those held by foreign parties) are being converted at a discount into tradeable shares (new G shares) that shall trade as A shares at the expiration of a statutory lock-up period. A merger of the A and B share markets is anticipated in the future as China moves to rationalize its capital markets.
Foreign investors have been precluded from acquiring the largest class of listed shares (domestic A shares), and acquiring a controlling interest in the non-tradeable shares (permitted since 2003) triggered a general tender offer requirement which a foreign investor could not satisfy due to its A share prohibition. Foreign investors were largely limited to acquiring listed B shares. This class of share however was quite small and illiquid, which precluded control transactions. Legal person and state-owned shares opened to foreign acquisition in 2003, but in limited controlled transactions. Recent regulatory changes, however, have expanded acquisition opportunities, so that control transactions are now technically feasible.
Listed Company Share Acquisitions
Depending on the share classification, foreign investors may acquire shares through a negotiated acquisition, a private placement, an open market acquisition or a block trade transaction. Different rules and restrictions apply to each class of shares, and each class has different ownership and transfer procedures. Valuations are required for most negotiated acquisitions and statutory lockups are applicable to many types of acquisition. The CSRC, SASAC and MOFCOM may be heavily involved in these transactions.
Listed Company Takeovers
The Administrative Measures on the Acquisition of Listed Companies (amended 2006) are applicable to acquisitions of over 30% of the outstanding shares of a listed company. Once the 30% threshold is reached any further acquisition must be made by general or partial tender offer. The minimum partial tender offer is for 5% of the outstanding shares. Prior to 2006, a general tender offer for all shares was required upon reaching the 30% threshold. The CSRC may grant exemptions from the tender offer requirements. In the past, the A share restriction has precluded foreign tender offers, but recent regulatory changes have opened the A share market to foreign participation, which would allow tender offers in certain circumstances.
Acquisition of A Shares
The A share market has been gradually opened to foreign investment. Foreign financial investment in listed A shares has been permitted on a limited scale for several years and the relevant rules on such investments were relaxed in 2006. A qualified foreign institutional investor ("QFII") under the rules is permitted to hold up to a 10% interest in the A shares of any particular listed company, with the combined QFII holding not to exceed 20% in any company. These rights, however, are of limited utility to operating investors.
The A share market opened to non-financial investors this year. The Administrative Measure on Strategic Investment in Listed Companies by Foreign Investors Procedures (2006) permit strategic investors meeting certain criteria to acquire A shares. The regulations do not limit the number of A shares that may be acquired, but require a minimum acquisition of 10%. A three-year lock up is applicable to the acquisition. The general foreign investment rules are applicable, and only listed companies that have undergone the share reform process for non-tradeable shares are eligible to receive such investment. The takeover regulations may apply to such acquisitions.
The recent 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.
The amended M&A regulations clarify the permitted use of share consideration. The previous regulations permitted its use without offering any procedural guidance, creating approval difficulties. The use of share consideration should now be practically feasible, although subject to significant restrictions. The foreign company involved in the transaction must satisfy certain restrictive criteria. Only listed shares (and not those traded OTC) having a relatively stable share price for the prior year may be used as consideration, subject to an exception for certain offshore restructurings. The opinion of a registered financial advisor is also required for the transaction. Approval is required both for the use of share consideration and the overseas investment resulting from the Chinese party's acceptance of such consideration.
The recent regulatory amendments have expanded valuation requirements. A valuation is required for most domestic asset acquisitions. The valuation must be undertaken by a licensed valuation organization, and separate regulations govern the valuation procedure. It is important to be involved in the process, which will establish 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 some transactions.
Related Party Transactions
Related party transactions and restructurings receive considerable attention under the amended M&A regulations. There are now stringent disclosure requirements for related party M&A transactions with anti-avoidance provisions that prohibit the use of trusts and other arrangements to disguise such relationships. Related party connections must now be specifically reported during the approval process.
Special Purpose Vehicles
The use of SPVs for offshore/onshore restructurings also received further attention with a focus on offshore restructurings for listing purposes. Fairly stringent criteria have been introduced for such reorganizations. MOFCOM and CSRC approval is required and the listing must take place within one year, otherwise the transaction must be unwound. The CSRC previously did not have approval authority over such offshore listings.
The amended regulations also require that acquisitions involving a key industry, impacting national economic security or resulting in the change of control of an entity with a well known domestic trademark be reported to MOFCOM. No guidance is provided on the meaning of such terms, but failure to satisfy the reporting requirement can result in the unwinding of an otherwise properly approved transaction.
China is beginning to examine market concentration issues. A draft anti-trust law is being considered and it is anticipated that the law will be adopted in the near future. Currently market concentration issues are considered as a part of the normal transaction approval process.
China has made considerable advances in the last several years in developing a coherent regulatory framework for M&A transactions. These regulatory developments have broadened the scope of permissible acquisitions and highlight China's ongoing commitment to honouring its WTO undertakings. A viable framework for M&A transactions in China has been established. With a wide range of available targets and acquisition methods, acquisition practices are being standardized and validated. Although MOFCOM has reasserted national approval requirements in some of the new regulations, the regulatory trend has been toward facilitating M&A transactions. 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.
Edwarde Webre is a partner in Deacons' China practice group. The practice group of 50 lawyers advises companies on cross-border transactional and operational matters, including mergers and acquisitions; reorganisations; direct investment (equity and cooperative joint ventures; wholly foreign-owned enterprises and foreign investment enterprises limited by shares); corporate finance (credit agreements; USA registered offerings and private placements); venture capital; technology licensing and transfers; operational and distribution arrangements; diligence investigations; real estate transactions; general commercial agreements; and labour matters.