Mergers & Acquisitions

Gone are the days when foreign companies wishing to invest in China were limited to greenfield investments. They may now purchase operating Chinese businesses and may restructure their existing investments in China through mergers, spin-offs, and holding companies that were impossible only a few years ago. These developments are not confined to foreign investors. Domestic Chinese companies are also merging and acquiring one another, and the more successful among them have begun to buy out foreign investors. The result of all of these developments is a rapidly expanding mergers-and-acquisitions (M&A) market in China.

China's regulatory regime has long been hostile to M&A transactions. That regime is changing, however, both to accommodate these recent developments and to further stimulate foreign investment. China's World Trade Organization (WTO) accession will no doubt accelerate these changes. Nevertheless, the Chinese government will continue to have compelling political and economic reasons for maintaining controls in many economic sectors, and China's business and legal environments will continue to pose obstacles to M&A transactions.

The legal framework for M&A

A web of restrictions and governmental approval requirements applies to foreign-invested enterprises (FIEs) from establishment through dissolution. Many of the more onerous restrictions on FIEs, such as minimum export requirements and required utilization of advanced technology, are being lifted in preparation for China's WTO entry.

Though Chinese law is becoming more flexible, the forms of M&A transactions, and accompanying procedures, authorized under Chinese law still differ in important respects from those in other jurisdictions. The available options generally depend on the result intended (acquisition, divestiture, or merger); whether the transaction involves other FIEs or domestic Chinese companies; and the extent to which the transaction takes place within Chinese regulatory jurisdiction. Transactions involving mergers or acquisitions with wholly domestic Chinese companies present their own problems and merit separate discussion.

Offshore transactions

The most effective way for foreign investors to avoid China's burdensome regulatory environment when transferring or acquiring Chinese business assets is to keep the entire transaction offshore. If an investment in China is held through an offshore company, such as a Hong Kong or Cayman Islands holding company, a second offshore company can simply purchase the shares of the first company under the laws of the applicable foreign jurisdiction. The Chinese government generally does not purport to regulate such offshore transactions and requires no PRC government approvals. If the offshore company owns an interest in an FIE in China, the consent of the Chinese joint-venture (JV) partner(s) is not generally required, unless the transaction requires amendments to the FIE's articles of association or joint-venture agreement. Figure 1 illustrates a typical transaction of this kind.

Many foreign investors structure their holdings in China through intermediate offshore holding companies, often one for each FIE, precisely to permit this flexibility for subsequent transfers of their interests. By using multiple intermediate offshore holding companies for different FIEs, corporate groups can also readily accomplish many forms of intracorporate restructuring without becoming enmeshed in the Chinese regulatory system.

Onshore-offshore transactions

It is sometimes impossible to keep the deal entirely offshore, even when the purchaser is another foreign company. When the transaction involves the transfer of an equity interest or assets in China, or from offshore investment into China, Chinese government approvals and the various regulatory restrictions on foreign investments in China will apply.

  • Sale of equity in an FIE to an offshore investor

    A foreign investor must sometimes sell an interest in an FIE directly to an offshore purchaser. This occurs, for example, when the seller holds its interest in the FIE without the benefit of an intervening offshore holding company. Even if an offshore holding company holds the China investment, that company may have other assets or liabilities that the seller seeks (or is compelled by the purchaser) to retain, making it impractical to sell the holding company outright. In such cases, the only option may be to sell the onshore ownership interest in the FIE directly to an offshore buyer (see Figure 2).

    Such transfers, in which the foreign purchaser can simply buy the existing investor's equity interest (expressed in terms of its registered capital), most often involve equity joint ventures (EJVs) or wholly foreign-owned enterprises (WFOEs). Transfer of an interest in a contractual joint venture (CJV) is possible but, because the parties' rights and obligations in a CJV need not follow the proportion of their capital contributions, such a transfer generally requires more complex contractual restructuring. Because the purchaser in all of these transactions is offshore, the transfer is subject to the approval requirements of the EJV, CJV, or WFOE laws, as the case may be, and, for a JV, to the Chinese party's consent as well.

    Another common onshore-offshore transaction arises when a Chinese partner in a joint venture sells its interest. This may occur either when the Chinese partner simply wishes to exit the business or as the result of a falling out between the parties. The foreign investor may then have no choice but to purchase the Chinese party's equity. If the foreign investor thereby acquires 100 percent control, the JV becomes a WFOE. If, as is sometimes the case, the business sector in question is regulated more strictly for WFOEs than for JVs, problems in obtaining the necessary regulatory approval may arise.

  • Foreign investments in domestic companies limited by shares

    The 1994 Company Law authorized SOEs to organize themselves as joint-stock companies and authorized direct foreign investment in those companies. The Provisional Regulations on Utilization of Foreign Investment to Reorganize State-Owned Enterprises, promulgated by the State Economic and Trade Commission (SETC) in September 1998, set out approval procedures for such investments. The regulations add SETC approval (local or national depending on the size of the investment) to the approvals already required for establishment of FIEs generally. The investment is also subject to general restrictions on foreign investment in specific economic sectors. If the transaction is approved and the foreign investor acquires 25 percent or more of the joint-stock company's equity, the company may be converted to an FIE. An acquisition of less than 25 percent will leave the foreign investor with a minority stake in a domestic Chinese company.

    Foreign companies have made several highly publicized investments of this character, of which the Eastman Kodak Co. deal is the most well known. SOEs, however, typically have problems that make them unattractive investment targets--aging plant and equipment, heavy debt burdens, and redundant workforces. There are, moreover, only limited protections for minority investors in Chinese corporations. As a result, foreign investors have been reluctant to pursue this form of investment.

    Nevertheless, China's desperate need to restructure and rejuvenate its SOEs continues to drive the government to experiment with new approaches to attract direct foreign investment in SOEs. Local "equity exchange centers" have been established in Beijing, Shanghai, and in Shenzhen, Guangdong Province, in some cases for specialized, high-technology deals. These centers are to serve both as sources of information on available deals and as, in effect, expediters for the government approval processes. Some localities have also begun experimenting with different approval processes for foreign investment in their jurisdictions. Shanghai, for example, does not apply the 1998 SETC Provisional Regulations but approves a broad range of transactions through the Shanghai State Assets Management Office and the local office of the ministry in charge of the industry in question. To what extent these procedures will overcome foreign antipathy to investing in SOEs remains to be seen.

  • Listed companies

    Foreign investors are currently authorized to buy only one category of shares, known as B shares, in Chinese companies listed on China's two stock exchanges (in Shanghai and Shenzhen). China has suggested that it may eventually open the A-share market to foreign investors as well. China does not, in any event, permit hostile takeovers of public companies through open-market purchases or tender offers without the consent of the China Securities Regulatory Commission. Private placements of unlisted state-owned shares in listed companies can generally only be made to other SOEs.

    Transactions within China

    FIEs in China can either buy assets from existing companies, or, by undergoing structural reorganization, invest directly in them.

  • Asset sales to foreign investors

    Asset sales are used in China, as elsewhere, when a buyer wishes to acquire a business but wants to avoid that business's existing liabilities. Asset sales are particularly attractive in China because of the unusual difficulties in identifying all of the liabilities of a target company. The foreign investor will generally be unable to hold the acquired assets directly. It will, therefore, either have to use an existing FIE or establish a new one. The establishment of a new FIE (with a Chinese partner if it is to be a JV) will be an onshore-offshore transaction, as discussed above. It will also be subject to applicable foreign-investment approval and qualification requirements. The actual asset purchase, however, will be an entirely onshore transaction between the seller and the new or existing FIE. There will be due diligence, financing, and closing issues (discussed below), but the transaction generally will not give rise to corporate structuring issues.

  • Corporate group structures for FIEs in China

    The structures of M&A deals by foreign investors in China are closely related to the corporate group structures permitted by Chinese law for foreign companies. Until the mid-1990s, PRC law did not readily permit one FIE to invest in another FIE or in a domestic Chinese company. Foreign companies were effectively compelled to conduct their investments in China through legally discrete FIEs linked offshore and could not use multi-tier corporate structures common in other jurisdictions. As a result, they could not efficiently centralize functions common to different companies within a corporate group, such as procurement, marketing, sales, invoicing, and after-sales servicing. Likewise, they could not consolidate profits and losses within a corporate group for tax purposes or balance foreign exchange among enterprises--a particularly important concern in China. China has recently liberalized its laws to permit two structures in which one FIE may hold an ownership interest in another: the holding company and the limited liability company. In both of these instances, foreign investors may be able to consolidate at least some of these common functions.

    Under the 1995 Holding Company Regulations, foreign companies may establish holding companies (or, as the regulations term them, "investment companies") to hold interests in any of the authorized forms of FIE. A foreign party seeking to establish a holding company must have good credit standing and either: at least $30 million of registered capital in 10 or more existing FIEs; or a minimum asset value of $400 million (calculated for its corporate group as a whole), total registered capital in existing FIEs of at least $10 million, and three additional, preliminarily approved investments in future FIEs. Holding companies may invest up to four times their registered capital, keep a higher leverage ratio than is permitted FIEs, and are not limited to investments in a single sector.

    Few foreign companies can meet the conditions required to establish a holding company. In practice, moreover, PRC authorities have denied holding companies the rights to perform many of the corporate group functions, such as foreign exchange balancing, that are their raisons d'etre. As a result, only about 200 foreign companies have established holding companies to date.

    In July 2000, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) and the State Administration for Industry and Commerce (SAIC) jointly issued Interim Provisions on Domestic Investment by Foreign-Invested Enterprises (FIE Investment Provisions), which took effect September 1, 2000. The FIE Investment Provisions authorize FIEs to establish new limited liability companies or companies limited by shares in China and to buy the interests of investors in an existing company. The company receiving the FIE's investment, whether newly established or already existing, is referred to as an "invested company." Nearly all FIEs may make such equity investments if they have paid in their registered capital, have begun operating at a profit, and have no history of illegal business activities.

    Except as otherwise restricted by China's Catalogue Guiding Foreign Investment in Industry (the Catalogue) (see below), there are no maximum or minimum investments under the FIE Investment Provisions. Thus FIEs may set up or acquire wholly owned subsidiaries or take minority stakes in Chinese companies. An invested company will generally not qualify as an FIE; for legal purposes it will be a wholly domestic Chinese company governed by the Company Law and other laws applicable to domestic companies in China. The FIE Investment Provisions also allow an FIE establishing a new Chinese company to make its capital investment in the form of an asset contribution. This permits an FIE to spin off the assets of one part of its business into a new subsidiary, which can then be merged with or sold to a third party.

    FIEs making investments under the FIE Investment Provisions are not holding companies. Each must be an operating company, and no more than 50 percent of the FIE's net assets may be invested in other companies. This 50 percent cap requires foreign investors to have one principal operating company with sufficient additional registered capital to hold equity investments in one or more smaller companies. Most foreign investors will prefer that the principal operating company be a WFOE so that they will have exclusive control over their investments in other companies. Current restrictions on WFOEs may make this impracticable in some industries. Investments via an EJV or CJV will, however, give the Chinese partner an interest in the resulting subsidiaries or affiliates that may not be desirable from a business standpoint and that, because of the Chinese JV partner's statutory veto rights, may create operational and legal problems in managing the investments.

    M&A between FIEs in China

    In addition to the earlier limitations on equity investments by FIEs, Chinese law previously made no clear provision for the merger or division of existing FIEs. This made even the most basic corporate restructuring difficult. In late 1999, China addressed this omission in the Regulations on the Merger and Division of Foreign-Invested Enterprises (M&D Regulations), issued by MOFTEC and SAIC. The M&D Regulations allow WFOEs, EJVs, and CJVs to merge with one another. The resulting entity may take any of these FIE forms. Companies have had only limited experience to date with mergers under the new M&D Regulations. Although the regulations permit a broad range of transactions in theory, two areas seem to be of greatest interest.

    First, the new merger options will facilitate intracorporate restructuring. Foreign investors wishing to consolidate their Chinese investments onshore--for internal reasons or perhaps to reflect offshore developments such as a merger of parent corporations--can now do so by merging their existing FIEs. This may also be an efficient way for foreign companies with joint ventures to structure a buyout of Chinese partners. A foreign company with two EJVs with different partners, for example, could merge the two and buy out the interest of either or both Chinese partners in the process (see Figure 3). (If both were bought out, however, the resulting entity would be a WFOE, a result permitted by the regulations presuming the resulting entity does not run afoul of sectoral restrictions.)

    Second, the new M&D Regulations permit, in effect, equity acquisitions of one FIE by another. Although the regulations permit various permutations, the surviving FIE from the acquisition will typically take the form of the acquiring party. For example, one WFOE merges with another; one of the two investors is bought out; and the resulting entity remains a WFOE. Or, one EJV merges with another; the parties to one of the joint ventures are bought out; and the resulting entity is an EJV. (Because CJVs are wholly contractual arrangements in which the parties' respective interests are not delineated by shares, mergers involving CJVs are likely to be more complicated.) The distinguishing feature of such transactions is that one entity survives with its original ownership structure and constituent documents intact and one dissolves--the transaction becomes an acquisition for the acquiring party and a potentially efficient exit mechanism for the party that is bought out (see Figure 4).

    M&A transactions with domestic Chinese companies

    Business combinations between FIEs and domestic Chinese companies have generally taken the form of joint ventures. The approval process for these JVs is cumbersome, requiring approval first of the project generally, then of a feasibility study, and finally of the joint-venture agreement itself and related documentation. Most JVs have been with state-owned enterprises (SOEs). Central government worries about misuse or diversion of state-owned assets have led to time-consuming valuation procedures for any assets contributed by the SOE to the venture. Many of these restrictions still apply, but the government's recognition that SOEs need capital infusions to be economically viable has led to liberalization of the rules in a number of areas.

  • Mergers with domestic Chinese enterprises

    The M&D Regulations specifically provide for mergers between FIEs and domestic Chinese enterprises. The relevant provisions of the M&D Regulations offer little guidance about the kinds of transactions contemplated. It seems likely, however, that the inclusion of domestic Chinese enterprises in the M&D Regulations may be useful in two kinds of transactions.

    First, in some circumstances a merger of existing entities may be the most efficient way to establish a new JV with a Chinese company. The foreign investor may, for example, already have an EJV with a Chinese partner and wish to combine the business of the existing venture with that of another Chinese company. A merger under the M&D Regulations will be reasonably straightforward, and the surviving entity will continue to qualify as an FIE as long as the foreign investor holds at least 25 percent of the equity. The alternative would be to establish an entirely new EJV, which would either require liquidation of the existing EJV or a two-level joint-venture structure. This method would be subject to the more cumbersome, multistage EJV approval system.

    Second, as noted above, the subsidiaries of operating FIEs under the FIE Investment Provisions are not generally treated as FIEs themselves; they are Chinese companies. The M&D Regulations therefore also permit these "Chinese" companies to participate in mergers and divisions under their terms. This may offer foreign investors holding Chinese subsidiaries somewhat greater flexibility in restructuring their investments than if they were to restructure as FIEs.

  • Chinese company as the buyer

    In recent years, several of the more successful domestic Chinese companies (Tsingtao Brewery Co. Ltd. for example) have bought out foreign investors. Reportedly, some of these companies are interested in consolidating their positions before China enters the WTO. Equally likely, the Chinese buyers have simply seen attractive opportunities to take over the businesses of foreign investors who wish to divest themselves of their Chinese investments.

    A Chinese buyer in an M&A transaction is typically an SOE, which will create several distinct problems in structuring and closing the transaction. In general, the original Chinese government authority that approved the FIE's establishment (whether a local Commission on Foreign Trade and Economic Cooperation, MOFTEC, or the State Council) must approve the purchase of the foreign party's interest in an FIE. Because the SOE uses state funds for the purchase, the assets or equity being acquired will also have to be valued by approved agencies. The foreign buyer will typically wish to be paid in hard currency offshore, for which the Chinese buyer will require approval from the State Administration of Foreign Exchange (SAFE) to convert renminbi (RMB) into hard currency to make the payment. The SAFE application cannot even be filed until all of the other approvals for the transaction have been secured. These approval procedures are all potential obstacles to closing the transaction, in addition to other required approvals. At best, they can delay closing, often by months.

    Some practical issues

    Some of the unusual practical difficulties of negotiating M&A transactions in China include the following:

  • Due diligence

    Publicly available records on many aspects of a Chinese company's business, such as legal title to land-use rights, the existence of pending litigation, and priority security interests over assets, are often either unavailable or unreliable. Corporate accounting is also frequently lax by foreign standards. And Chinese companies, particularly SOEs, are accustomed to rigid secrecy policies and may be uncooperative in disclosing their records. As a result, conducting satisfactory due diligence can be difficult. Under these circumstances, most foreign investors will want comprehensive representations and warranties, indemnities for breach, and security for those indemnities. These arrangements are unfamiliar to many Chinese companies, and obtaining acceptable terms and conditions that incorporate them is often a challenge.

  • Financing

    Numerous obstacles complicate debt financing for M&A transactions. FIEs are most often the acquisition vehicle but are subject to maximum leverage ratios that cap their borrowing ability. Existing FIEs may already have used up some or all of their authorized borrowing. Because procedures for pledging equity interests or registering security interests in assets are not fully developed, and because enforcement of such interests is difficult at best, banks are often unwilling to loan funds for acquisitions. Even cash payments can give rise to problems because of the inconvertibility of the RMB. If the Chinese party is required to make the payments in hard currency, it may be unable to obtain SAFE authorization for the conversion. When the foreign party is bringing new funds into China to make the acquisition, it must consider that, once converted to RMB and registered in the FIE's capital account, its funds may be difficult to convert back to hard currency and repatriate later.

  • Taxes

    In June 2000, the State Administration of Taxation issued the Circular Concerning Several Income Tax Questions Concerning Enterprise Equity Investments. The general rules are typical of those elsewhere: profits derived from the sale of an investment in an FIE or Chinese domestic company are taxable income; a withholding tax of 10 percent applies if the seller is an offshore company; and transfers among affiliated enterprises may not be taxable events but may require adjustments in the cost basis for the investment. Many other complex tax and accounting issues may arise, some of which the circular addresses and others of which remain to be elaborated upon.

  • Closing

    Most M&A transactions in China require approval from an examination and approval authority (EAA). The EAA will typically not advise the parties when approval will be granted and will not make its approval conditional on future events, such as payment of the purchase price. Approval, however, in the form of an "approval certificate," transfers ownership. The seller will not want to initiate a government approval process that may result in the legal transfer of its assets to the buyer without payment in advance or a satisfactory guarantee of payment. Conversely, the buyer will not want to pay the purchase price until government approvals have been obtained and actual transfer of ownership is assured. (The buyer may also want to insist on an amended business license as a condition of payment, which requires action by the registration authority and can take additional weeks.) As a result, it is virtually impossible to effect a simultaneous closing of a Chinese M&A deal. Various escrow and letter-of-credit arrangements are sometimes used to bridge the gap, but the laws governing these arrangements are not well developed in China.

    The future of M&A in China

    Multinational corporations are constantly seeking to restructure their businesses to improve efficiency and profitability. This restructuring, often via M&A transactions, can only be effective if it can be accomplished quickly and through reliable procedures. These requirements of international business clash directly with China's longstanding preference for state planning of the economy generally and tight controls over foreign investment in particular.

    The recent changes in Chinese M&A laws reflect China's movement toward a legal and economic structure that will accommodate the requirements of international business. China's need for more foreign investment, and the legal obligations China will undertake in joining the WTO, will continue to push China in this direction. For M&A transactions, the most significant impact of China's WTO entry may be the country's implementation of its commitments to open, or raise the limits on the maximum foreign investment permitted in, several important service sectors, notably telecommunications, insurance, and banking. China has also agreed to eliminate prohibitions on foreign distribution activities in China, which will effectively broaden the authorized business scopes of many existing FIEs and permit investment in a much wider range of distribution and retail activities. The result will be an M&A market that is larger and increasingly relevant to both foreign and domestic companies in China.

    The State Approval Process for Foreign-Invested Enterprises

    The 1998 Catalogue Guiding Foreign Investment in Industry (the Catalogue) divides foreign investment into four categories: encouraged, permitted, restricted, or prohibited. More than 300 industries are grouped by these categorizations, which guide approval authorities in deciding whether to authorize a new wholly foreign-owned enterprise or joint venture. The categorization may also confer benefits or impose restrictions. "Encouraged" projects, for example, may be approved by a local examination and approval authority (EAA) under circumstances that would require Ministry of Foreign Trade and Economic Cooperation (MOFTEC) approval for other categories; "restricted" projects may have limits on the maximum percentage of foreign ownership; and "prohibited" industries are barred to foreign investment altogether.

    The Foreign-Invested Enterprise Investment Provisions (FIE Investment Provisions) and the Regulations on the Merger and Division of Foreign-Invested Enterprises (M&D Regulations) include elaborate safeguards to ensure that the guidelines cannot be circumvented through an investment or acquisition. If, for example, foreign investment is limited in a particular sector, the total equity held, directly or indirectly, by foreign investors may not exceed that limit as a result of a merger under the M&D Regulations. Along the same lines, the local EAA, rather than the local registration authority, must approve an investment in a "restricted" industry under the FIE Investment Provisions, and much more documentation must be submitted with the approval application than for investments in "encouraged" or "permitted" sectors.

    The M&A approval process

    One or more Chinese governmental authorities must approve every form of foreign direct investment in China and every type of onshore or onshore-offshore merger or acquisition. The specific approval procedures for establishing the various forms of FIEs and for approving the various forms of merger-and-acquisition transactions vary but have common characteristics.

  • The examination and approval authority MOFTEC or local commissions on foreign trade and economic cooperation (COFTECs) must approve the establishment of every FIE. Chinese law refers to the government authority as the EAA. The documentation necessary for this approval process depends on the specific form of FIE for which the application is made. The EAA retains jurisdiction over the FIE throughout its life, conducting an annual examination of the FIE's compliance with Chinese law and approving or disapproving changes to its registered capital, "total investment amount" (registered capital plus authorized debt), or investment structure. Most of the M&A transactions described in this article require the express approval of the relevant FIE's EAA.

    Whether an FIE's EAA is MOFTEC or a local COFTEC generally depends on the FIE's total investment amount, which must be stipulated in the FIE's approval documents. COFTECs may approve all investments under $30 million and those of up to $100 million in encouraged sectors. FIEs with total investment amounts over $30 million (or, if applicable, $100 million) require MOFTEC approval. Though many FIEs have divided large projects into smaller ones or structured projects in stages to get quick approval at the local level, few have been questioned about their circumvention of the approval procedures. Such noncompliance with statutory requirements may, however, give authorities the option to invalidate the entire investment later if they choose.

    In contrast to China's other foreign investment laws and regulations, the FIE Investment Provisions authorize FIEs to establish new Chinese subsidiaries, or to purchase interests in existing FIEs or domestic Chinese companies, in encouraged or permitted sectors (as defined in the Catalogue) by applying not to the EAA but to the local administration for industry and commerce or "registration authority." The FIE must file only limited documentation with the registration authority. The clear implication is that approval of such investments should be routine. If the FIE invests in a company whose business is in a "restricted" sector, however, the FIE must apply to the appropriate EAA.

  • The registration authority and business licenses When the EAA has issued an approval certificate to an FIE, the FIE must apply for a business license to the local registration authority. The regulatory authority also decides requests to amend business licenses. This includes changes to the license necessary to consummate an acquisition or investment. For example, an acquisition in the form of a merger under the M&D Regulations may result in the surviving party acquiring a line of business not authorized by its existing business license.

    Ensuring that the scope of the FIE's business is accurately described in its license is important. China delimits the business scope of both FIEs and domestic companies much more narrowly than do most jurisdictions. Operating outside the scope of a license can result in fines and even termination of the license.

  • Approvals of other agencies As in other countries, particular industries are directly regulated by specific ministries or agencies. In China this is true of banks and insurance companies, among others. Foreign investments or M&A transactions in these areas may require the approval of the regulatory agency. Even where explicit approval is not required, consultation between the local EAA and the regulatory agency is common.
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