Mergers & Acquisitions

Introduction

The People's Republic of China has emerged as a major destination for merger and acquisition ("M&A") transactions in Asia. Foreign investors are increasingly using M&A transactions to establish or expand their Chinese operations. M&A transactions are now complementing, and even rivalling, traditional green field foreign investment in China as a means of market entry or expansion. As China plays an increasingly important role in the global supply chain and economy, determining the optimal market entry or expansion method is a significant issue for many companies.

For a foreign investor looking to establish an export manufacturing base in China or tap its growing domestic market, an M&A transaction may offer a speedy viable alternative to green field investment. 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 for foreign companies desiring to invest in China.

M&A is accounting for an increasing percentage of the foreign direct investment ("FDI") flowing into China, as many investors are favouring acquisitions over new establishments to speed market entry. The number and size of foreign related M&A deals has been growing steadily, while purely domestic M&A activity is growing as well. Domestic regional companies are using acquisitions to become national, while national PRC companies are also using acquisitions to become global. Growth through M&A in China is an increasingly important strategy for both domestic and international companies with operations in China.

The increased pace of M&A activity has attracted the attention of the Chinese authorities, who have issued new and amended M&A related regulations in recent years to streamline the acquisition process and to address national and global M&A practice developments, including perceived practice abuses. These regulatory developments have generally clarified and facilitated the acquisition process, while retaining and expanding slightly the discretionary power of the central authorities to review and approve M&A transactions, which remains a distinctive characteristic of the Chinese legal system. Recently, China's primary M&A regulations and its listed company M&A regulations have been significantly amended. Regulations permitting strategic foreign investment in the A shares of listed companies have been issued and significant amendments have been made to the PRC Company Law and the PRC Securities Law. China has also promulgated its first Anti- Monopoly Law, which became effective in August of 2008, and is now being tested in
practice. While the regulatory changes have imposed certain additional practice restrictions, the new opportunities created by the changes, such as permitting the use of share consideration in acquisitions, should encourage further M&A activity in China.

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. The government has a far more extensive involvement in M&A transactions than is typical in other jurisdictions. These agencies do not merely act as competition regulators. Their concerns are not limited to the competitive consequences, market concentration impact and formalities of a transaction. They play a broader role, substantively reviewing and approving deal terms. They may even request changes to the purely commercial aspects of a transaction. They naturally will also often have social concerns unrelated to the economics of the transaction. Discretionary approvals are required for nearly all transactions. Pervasive approval requirements are a distinctive feature of M&A transactions in China.

These discretionary approvals are not mere formalities, and may take considerable effort to obtain. These approval requirements are not limited to transactions involving the state sector, even private sector M&A transactions are subject to a basic review of commercial terms. 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. A few agencies have broad authority over such transactions, while others handle specific elements of a transaction. The division of authority between the various agencies is not always clear, and turf battles between agencies are not uncommon. Local agencies may often have
expansive views of their delegated authority that are not consistent with the applicable regulations. Dealing appropriately with the agencies is important for ensuring a successful transaction and obtaining local support for ongoing operations.

The agency with the most important role in the M&A process is the Ministry of Commerce ("MOFCOM"), formerly the Ministry of Foreign Trade and Economic Cooperation, which has the primary responsibility for supervising foreign related M&A transactions, and it will be involved in all M&A transactions. It is China's primary foreign investment regulator and
approval authority. The recent amendments to the M&A regulation have strengthened its hold over the transaction process and its right to review transactions.

The National Development & Reform Commission ("NDRC"), formerly the State Planning Commission, is also an important agency in the M&A process. It is responsible for both approving foreign investment project applications and supervising the restructuring of state-owned enterprises. It plays an important role in verifying foreign investment projects.

The State-Owned Assets Supervision and Administration Commission ("SASAC"), which has supervisory authority over state-owned assets, plays a significant role in transactions targeting state-owned enterprises and assets. It closely monitors transaction values and payment schedules. It may act as both regulator and vendor through one of its designated agencies or companies.

The China Securities Regulatory Commission ("CSRC"), which is responsible for monitoring and regulating China's capital markets, will be involved in transactions targeting listed companies. As listed company acquisitions become more common, it will play a greater role in the M&A process.

The State Administration of Foreign Exchange ("SAFE"), which has supervisory authority over foreign exchange flows and domestic offshore investment, will be involved in a transaction when certain types of consideration are used and when certain transaction structures are employed. SAFE will play a greater role in M&A transactions as more PRC
companies make investments abroad and more companies undertake offshore restructuring to access foreign capital.

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.

In dealing with these agencies in the transaction process, it is important to remember that the government is not an integrated monolith. Different agencies have different agendas and constituencies. The support of one agency does not necessarily imply the support of another, and the national and local authorities may hold divergent views on an issue. Local
agencies tend to be more flexible than their national counter-parts and occasionally may stretch their authority. Agencies may also hold conflicting views about the scope of their relative authority. Considerable care is necessary in dealing with these agencies.

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.
The establishment of each type of these FIEs is subject to PRC government approval. 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 the enjoy certain benefits, although the tax benefits previously enjoyed by such entities have been eliminated for new entities by changes to the PRC's tax regulations, and phased-out for entities with pre-existing tax holidays.

Investment projects are classified by industry sector in the Catalogue for the Guidance of Foreign Investment (amended 2007) (the "Catalogue") as "encouraged", "permitted", "restricted" or "prohibited". The Catalogue is periodically amended to reflect changes in government policy. China's WTO accession commitments are reflected in the Catalogue. 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. Specific National approvals may be required for certain types of project. There is also a specialized catalogue for projects in the West of China, where foreign investment has traditionally been more limited, which provides for more beneficial foreign investment terms.

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.

M&A Regulations

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. The overhaul resolved some inconsistencies in the prior regulations and addressed and standardized some new practice developments.
The harmonization of regulations, however, was not complete and inconsistencies remain as many supporting regulations were not modified to reflect the changes in the primary regulatory framework. Under China's civil law system, even basic types of business transaction may be subject to extensive regulation and required authorizations. The absence of regulation does not imply a license to engage in a business activity.

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 on pricing. Many practices common in other jurisdictions are restricted in China. The regulations limit the parties’ freedom of contract.

M&A Approvals

The specific approvals required for a particular 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. However, the amended rules have strengthened some of the macro-controls concerning such transactions, establishing National level reporting requirements for certain exceptional transactions, which may be approved locally, and requiring National approvals for connected party off-shore restructuring transactions in all cases.

In general, transactions involving encouraged or permitted sector targets (as defined in the Catalogue) with a transaction amount of more than US$100 million will require a national level approval, while such projects with a transaction amount of US$100 million can generally be approved locally. Restricted transactions with a transaction amount of more than US$50 million 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 and the specialized regulations are generally not amended concurrently with revisions to the primary regulatory structure.

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 a variety of considerations, such as the financial condition of the target, the required government approvals, the necessity of third party consents, the transferability of the target assets and the tax consequences of the structure.

Equity Acquisitions

A foreign investor may directly or indirectly acquire equity (either registered capital or shares) in a target from existing investors or the target. In an equity 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 has also been popular for early stage venture capital investments. Chinese entrepreneurs will often restructure their domestic enterprise into an FIE owned by an offshore holding company to permit venture capital investors to invest in the offshore holding company. This structure facilitates the eventual exit of the venture
capital investors though disposal of the offshore interest without PRC approvals and permits them to invest using 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 enterprise will be required to convert into an FIE, 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, as this fundamentally changes the enterprise's operating rules.

Asset Acquisitions

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. There, consequently, 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. Corporate authorization beyond that provided for in the company's underlying corporate documents may be required for the transaction. The authorities will insist on a board resolution. The authorities will also require a letter of creditworthiness for the acquirer..

There are special rules applicable to asset acquisitions targeting the substantial assets of a listed company. Various requirements are imposed depending on the relationship of the assets to total asset value and core business revenue..

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. Appraisal work may be required with respect to the assets. Creditors’ notification is sometimes required. Arrangements concerning product
warranties will be practically necessary. Care should be taken in reviewing the liabilities of the target even in asset deal as creditors will often expect the acquirer to settle the debt as a practical matter.

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. The workers will often have expectations of additional payments from the acquirer, even absent a legal obligation of the acquirer's part to pay such amounts.

A review of the customs status of the assets to be acquired will also be necessary. Customs approval and the payment of supplemental duty may be required if any of the acquired assets are under customs supervision. There may be challenges is getting customs to accept such payment and release the assets from supervision depending on the remaining duration of the supervisory period. The customs supervision period is five years, and customs may be unwilling to act if the supervisory period is due to expire within a relatively short period of time. This can impact the timing of closing a transaction.

An asset acquisition will incur asset transfer fees and the transfer of various assets will require new ownership registration. Asset transfers may face particular issues concerning land, as not all types of land use right are transferable. The release of bank security arrangements may create timing issues. Acquired assets cannot be utilized prior to the
establishment of the operating entity.

Mergers

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, or two existing entities may amalgamate into a new entity, while the existing investors’ equity is transformed into merger consideration.

A merger is subject to the satisfaction of numerous conditions. A merger agreement, which is subject to government approval, is required to set out the particulars of the transaction. The merger candidates’ must have received their capital contributions in full, and the parties to a merger must make employment arrangements for the original employees. Creditors are required to be notified and have the statutory right to require debt repayment or the provision of adequate security as a condition to the consummation of the merger. The foreign investor in the merged company is required to hold a minimum of 25% of the post-merger company's registered capital in order for the company to enjoy
FIE status.

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. Mergers are typically time consuming transactions, and are more commonly used to rationalize post-acquisition
organizations rather than as the primary acquisition method. Statutory mergers are not yet popular in China. The merger regulations have not been updated to reflect changes in the general regulatory structure. There is a complex tax structure applicable to mergers. Considerable tax liaison work is necessary in undertaking a merger.

Domestic Targets

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. Slightly different rules are applicable to the acquisition of each type of entity.

The rules applicable to M&A transactions involving listed companies vary the most from the general M&A regulations. Such acquisitions continue to be covered by separate regulations based on share classification, although the process of converging the different share classes is well underway.

Transactions targeting FIEs have long been regulated and subject to regulations that differ from those applicable to the acquisition of purely domestic 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 for 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. The new regulations repeal the Interim Provisions on the Acquisition of Domestic Enterprises for Foreign Investors, which provided the initial regulatory framework for acquisitions. Older regulations still
apply to the acquisition of FIEs.

The regulations map out the approval procedures for such acquisitions. 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. Such acquisition remains subject to the restrictions of the Catalogue for
Guiding Foreign Investment.

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 transformation 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 into equity 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, which generally consists of a minority of tradeable listed shares and a majority of non-tradeable state-owned and
legal person shares, precluded public control transactions. A foreign investor was not permitted to hold all classes of listed shares. There are two main classes of domestically listed shares: A shares for domestic investors and B shares for foreign investors with a few exceptions for each. 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 also anticipated in the future as China moves to rationalize its capital markets. Consequently, the issuance of new B shares is quite limited and such issuance and the transformation of shares into listed B shares is not being encouraged. China is in the process of reforming its complicated share classification system and converging the classes of shares, which should eventually produce one class of tradeable shares.

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 that a foreign investor could not satisfy due to its A share ownership prohibition. Foreign investors were largely limited to acquiring listed B shares. This class of shares however normally makes
up only a small portion of a listed company's equity and is generally illiquid, which precluded control transactions. Legal person and state-owned shares opened to foreign acquisition in 2003, but in limited controlled highly regulated 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

There is a specific regulatory framework applicable to listed company acquisitions. Control acquisitions are subject to special regulations and may be trigger tender offer obligations. The Administrative Measures on the Acquisition of Listed Companies (amended 2008) 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 restrictions precluded foreign parties from making tender offers, but
recent regulatory changes, which opened the A share market to foreign investors, make foreign participation in tender offers feasible.

The take-over regulations now permit the use of non-cash consideration, allowing the use of equity consideration and more complex structuring arrangements, in such a tender offer, although cash consideration must always be make available. CSRC approval is required for a takeover by agreement.

The take-over regulations explicitly permit foreign investors to participate in the takeover of a listed company, subject to obtaining all required relevant approvals and complying with the rules applicable to foreign investment in listed companies. The strategic investor regulations issued with respect to foreign investment in A shares are an important step in
making the theoretical rights under the takeover regulation practically exercisable and facilitating foreign participation in listed company acquisitions, which is now beginning to occur.

There are disclosure and reporting issues connected with the acquisition of listed shares. Significant disclosure is required in connection with a tender offer. A written takeover report must be submitted to the CSRC and the local stock exchange. Pricing rules establish the minimum offer price. Cash or shares can be used as consideration and the duration of the tender offer is subject to time limitation. A registered financial advisor must be engaged to review the transaction from a legal and business perspective.

The board of directors of the target plays an important role in such transactions. It must make a recommendation to shareholders on the offer, and board members are not permitted to resign during the offer period. A company is also prohibited from undertaking certain defensive actions, such as major asset sales or significant transactions, during the
tender period without shareholders’ approval.

Significant disclosure and reporting requirements attach to holding a 5% interest in a listed company. The reporting requirements, however, have been simplified from the prior reporting requirements. The regulations contain significant definitions of parties "acting in concert" and "control" for the application of the reporting requirements.

Acquisition of A Shares

Pursuant to China's ongoing share classification reform, the A share market is opening more fully to foreign investors. With the share reform process gradually rendering nontradeable shares tradeable and the expanded opening of the A share market to certain types of non-financial foreign investor, the possibility of foreign companies obtaining control of a listed PRC company through the equity market is becoming a real possibility. Regulations issued in 2006 have opened the A share market to strategic investment by foreign firms satisfying certain investment criteria. The criteria to be satisfied under the foreign strategic investor program is far less stringent than applicable to investors under the qualified financial institutional investor regulations and targets more operating oriented investors. Financial investors and strategic investors are subject to different investment rules and holding restrictions.

Financial Investors

The A share market initially opened to foreign financial investors. 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. Foreign financial investors were given the investment opportunity pursuant to the Interim Provisions on the Administration of Security and Investment in China by Qualified Foreign Institutional Investors, which established a framework for permitting limited foreign financial investment in the A share market. The investor must satisfy a rigorous qualification criteria, which disqualifies all but the largest funds from acting as a financial investor. A qualified foreign institutional investor ("QFII") under the rules is only 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, as the shareholding limitation effectively precluded the possibility of obtaining management control. The QFII rules, however, are undergoing further liberalization.

Strategic Investors

The A share market opened to non-financial investors last 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 strategic investor regulations require a minimum acquisition of 10% and does not limit the percentage of A shares that may be acquired. The acquisition of a controlling stake is thus possible. A three-year lock up is applicable to such acquisitions. The general foreign investment rules are also applicable and only listed companies that have undergone the share reform process for converting non-tradeable shares into tradeable shares are eligible to receive such investment. The regulations explicitly require consideration of anti-trust related issues in screening strategic investor candidates. The takeover
regulations may apply to such acquisitions.

The strategic investor regulations authorize several methods of share acquisition. A strategic investor can acquire A shares through a directed private placement from a listed company or through a negotiated acquisition from existing shareholders. Each type of acquisition requires slightly different documentation, although internal Board of Directors and shareholder general meeting approval is required for either. The regulations set out the required application documents, which include a strategic investment plan, which must disclose the purpose of the investment and any relationships between the foreign investor and the controlling shareholder of the listed company. The acquisition contracts are subject to CSRC review.

It is expected that the A share market will further open to foreign investment. Pursuant to the share structure reform, even legal person shares held by foreign investors may be converted into tradeable A shares. Once the statutory lock-up period has expired, more foreign investors will be holding tradeable A shares.

Acquisition of Legal Person and State-Owned Shares

The foreign acquisition of legal person shares in listed companies was prohibited in 1995. The restriction, however, was lifted in 2003 pursuant to the Notice on Relevant Issues Regarding the Transfer of State-owned Shares and Legal Person Shares of Listed Companies to Foreign Investors. The Notice outlines a regulatory framework for the transfer of non-listed shares to foreign investors. The approval procedure for such
transactions involving state-owned shares was further clarified by the Notice on Issues Concerning the Application Procedures for the Transfer of State-owned Shares in Listed Companies to Foreign Investors and Foreign Investment Enterprises, which was issued in 2004. Further measures setting forth the technical transfer procedures were issued in
early 2005.

A foreign investor wishing to acquire legal person shares or state-owned shares in a listed company must satisfy certain investor qualifications to demonstrate the benefits of its investment. The acquisition is subject to PRC government approval. The purchase price must generally be paid with either convertible foreign currency or renminbi profits generated by other investments in China. The purchase price is generally determined with reference to the net asset value of the target.

Such shares are subject to a twelve month lock up period commencing from the payment in full of the purchase price. Conversion into an FIE may also be required in connection with such acquisition, although the target may not enjoy the benefits typically available to FIEs.

It is not clear, however, whether such transactions will continue, given the PRC government's current focus on share reform and eliminating non-tradeable legal person shares. Acquirers of such shares may be compelled to participate in the share reform process. While the acquisition of legal shares has been popular, recent reform efforts are likely to channel further investment away from legal person shares and toward the more
interesting A share markets.

Regulatory Developments

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.

Share Consideration

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 become 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 use of share consideration in a transaction. In practice, volatile share markets have prevented the utilization of this option.

Interim approvals are used to monitor these transactions. These transactions require sequential approval first for use of share consideration and then for investment overseas by the Chinese party receiving the shares. Both sets of approval criteria must be satisfied. The use of share consideration is not a short cut to offshore investment for Chinese entities. The offshore investment approval process is still applicable and the transaction will be unwound if the offshore investment approval is not obtained. Approvals for these transactions are not yet as yet freely forthcoming.

Valuation

The 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 is intended to prevent both underpayment and over payment for assets. 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.

Connected party "round trip" offshore restructurings, pursuant to which domestic investors restructure their domestic enterprise into an FIE, are now denied FIE treatment without the injection of additional funds and such restructurings are now required to receive MOFCOM approval, regardless of the level of approval that would normally be required. These regulations may make restructurings for venture capital transactions more difficult, resulting in a higher degree of MOFCOM involvement.

Special Purpose Vehicles

The use of special purpose vehicles for offshore/onshore restructurings also has 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.

Special Reporting

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. Little guidance is provided in defining such criteria, but failure to satisfy the reporting requirement can result in the unwinding of an otherwise properly approved transaction.

Interim Approvals

The M&A regulations now make significant use of annotated approval certificates. These annotated approval certificates impose conditions that must be satisfied within a defined period of time or the certificate will cease to be effective. When interim approval certificates are used, conditional unwinding documents must be submitted with the transaction application to provide an automatic means of restoring the status quo if the conditions in the annotated approval certificates are not satisfied. These approval certificates are being used for transactions involving share consideration and restructuring for an offshore listing.

Individual Shareholders

The restrictions on individual PRC shareholders in FIEs have also been relaxed. Chinese law generally does not permit individual Chinese nationals to hold equity in FIEs. This rule was relaxed under the prior M&A regulations, which permitted an individual to retain existing equity with MOFCOM approval provided that the shares had been held for at least
a year. The new regulations eliminate these requirements and allow existing shareholders to retain their interests without any special approvals. The change of the nationality of any individual shareholder will not affect the status of an existing enterprise.

Anti-Monopoly Review

China is beginning to examine market concentration issues. A new anti-monopoly law, which went into effect at the beginning of August, has added an additional level of complexity to acquisitions. Pursuant to the law, notice filings are required for acquisitions meeting certain statutory guidelines. The state anti-monopoly enforcement authority has 30 days from the receipt of the filing to decide whether the transaction should be subject to a further review. The law sets forth the documentation that must be filed. The transaction cannot be completed until the notice period and any additional review period have concluded. The filing requirements extend to both equity and asset acquisitions, as well as other forms of arrangement that shift control of business operations. The antimonopoly measures are being developed in a manner consistent with international practice.

Pursuant to filing guidelines issued by the State Council, anti-monopoly filings shall be required for an acquisition transaction if (1) the parties to the transaction have cumulative global revenue exceeding RMB10 billion in the prior year and two of the parties involved in the transaction have annual revenue in China exceeding RMB400 million in the prior year,
or (2) if the parties to the transaction have cumulative revenue in China of RMB2 billion in the prior year and at least two parties to the acquisition have revenue in China exceeding RMB400 million in the prior year. The authorities also have the discretion to investigate transactions that do not satisfy these criteria if there is evidence that the transactions
would have an anti-competitive effect.

These criteria are relatively straightforward and based on revenue rather than market share. This avoids more the difficult and subjective determination of parties’ market share and the relevant market segment. The filing guidelines, however, do not provide much guidance on the calculation of revenue.

These regulations may add an additional level of complexity to PRC M&A transactions. Market concentration issues were previously considered in reviewing transactions but the new regulations add another formal level of complexity to an already discretionary approval process.

Conclusion

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.

 

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