Complexities of China's M&A reforms are well worth it
- China
- 06/19/2007
Foreigners investing in China over the past few decades can certainly identify with the Confucius saying, “Life is really simple, but we insist on making it complicated.” That remains true today in many ways. However, changes are underway that will likely improve the situation.
As a country experiencing unprecedented economic growth, China has to constantly find the delicate balance between fast-paced economic development fueled by foreign investment and social and political stability. It is searching for an equilibrium that best suits its ascendancy in the global community while ensuring that wealth distribution, pollution and other adverse effects of economic development are within controllable limits at home. Foreign investment has underwritten much of the progress. Recent changes to the resulting regulations and philosophy governing foreign investment appear likely to have the result of making inbound investment, if not easy, then certainly more user friendly.
The changes come at a time when China is addressing social inequality and a widening wealth gap—issues that have been exacerbated in the past few years as the economy enjoyed tremendous growth. President Hu Jintao continues to shine a light on the rapidly widening gap between China’s rich elite and its poor. The Chinese Communist Party Central Committee’s annual plenary session in October 2006 made building a “harmonious society” and social equality its main focus.
The social inequality in China has been highlighted by a number of reports. A Merrill Lynch & Co. estimate from 2006 asserts that over 300,000 mainland Chinese have a net worth that exceeds U.S. $1 million. A separate Boston Consulting Group report estimates that China’s millionaires control over U.S. $500 billion in assets. By contrast, the results of a survey conducted by the National Bureau of Statistics last year show that the bottom 10 percent of urban populations in China hold only two percent of the total wealth in the cities. This social imbalance has been caused in large part by the market reforms that have taken place over the last three decades, which have also raised overall living standards, even for the poorest, in a very short period of time.
History has shown that large gaps in wealth can lead to social instability and unrest. China’s success in the long run and the ability of foreign investments to thrive will benefit from a reduction in the wealth gap and therefore the risk of social unrest. The recent changes to the regulations governing foreign investment are a mechanism to control this growing wealth gap.
Revisions to China’s key rule on mergers and acquisitions, known as the Provisional Regulation on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, became effective September 8, 2006. They come at a time of intense interest among foreign investors to buy companies in China and a general scrutiny of China’s regulation of foreign investment.
The revised rule affects a wide range of situations and parties, including foreign investors who wish to buy an equity stake in a domestic Chinese company; subscribe to an increase in the capital of a domestic Chinese company, thereby changing it into a foreign investment enterprise (FIE); or take over the assets of Chinese companies. It also introduces new compliance obligations for domestic companies using offshore special purpose vehicles to list overseas, the so-called “red chip listings.”
The revised rule has been issued by six governmental agencies, rather than four in its most recent incarnation. (See sidebar on page 23.) This means that foreign investors looking to buy an interest in a Chinese company will have to comply with more governmental bureaucracies. The Ministry of Commerce (MOFCOM) in particular has broad discretionary powers, and its leadership role in the approval process should be noted. How it will exert its power in relation to the additional reporting obligations has so far been untested.
The level of coordination among governmental departments in revising the rule should be seen as a positive development. While the potential involvement of all these governmental authorities for one investment may seem intimidating, the more defined and regulated framework provides all parties with a clearer understanding of what is required to complete a transaction. Foreign investors in China have experienced some official decision-making opacity over the past few decades. Any steps toward clarity and transparency would be a benefit.
The revised rule, among other things, introduces more stringent supervision of the domestic company to be acquired. While approval from the relevant authority may have sufficed under the old regulation, foreign investors in certain sectors will now be required to comply with additional reporting obligations at the MOFCOM level. Factors to be considered include the impact of the transaction on national security; competition in the market; fairness and reasonableness of the transaction; social, economic and public benefits; potential foreign control of famous Chinese trademarks or brands; and investment in certain key industries.
The precise documents and level of detail required will depend on the type of transaction and are potentially subject to additional requests by governmental authorities. The timing will vary as approval may be required on multiple levels in multiple governmental agencies.
Compliance is vital, and erring on the side of caution is wise. If a transaction takes place without the necessary approvals, MOFCOM can demand that the parties terminate the deal or take action to eliminate its impact. The interests of the foreign investor won’t likely be a priority.
Another change impacts those looking to buy publicly traded shares of companies listed in China. Foreign investors can now do so under the revised rule, and under the “Measures for the Administration of Strategic Investment in Listed Companies by Foreign Investors,” another rule referred to in the revised regulations.
Previously, such shares could only be bought by Qualified Foreign Institutional Investors (QFII.) These are investment companies or funds that have complied with a series of statutory requirements, been approved by the China Securities Regulatory Commission (CSRC) and have obtained an investment quota from the State Administration of Foreign Exchange in China. Other non-QFII investors could only acquire non-tradable shares of PRC-listed companies.
Thus, a new area is opened up for foreign investors, but there is a catch. The opportunity is limited to companies listed on Chinese stock exchanges (the Shenzhen Stock Exchange and the Shanghai Stock Exchange) that have completed share trading reforms or to newly listed companies, and comes with a required three-year lockup period during which investors cannot sell their shares. The good news is that the revised rule finally begins to address equity-payment-based takeovers of domestic enterprises by foreign investors—more commonly known as cross-border share swaps.
Cross-border share swaps involve a foreign company purchasing equities in a domestic company using equity it holds in an overseas company. Previously there were no official guidelines or rules for investors to follow when conducting these types of transactions. Such a transaction requires the submission of an application to MOFCOM for approval. A consultant within China must be hired to prepare a report on the genuine nature of the application documents and the financial status of the overseas company, among other requirements—a complicated process which must follow a strict timetable. While additional rules may not sound like a step forward, the additional clarity and increased transparency and the introduction of a timetable for the approval process are advantageous to investors engaging in these types of transactions.
There are also new rules about how domestic companies that have undertaken a red chip listing must repatriate the funds raised. Although uncertainties in implementation and interpretation remain, those domestic companies must report to MOFCOM within 30 days of the listing with the details of the event and how they plan to transfer those proceeds back to the PRC. The prospect of mandatory repatriation may cause some entrepreneurs and foreign investors to look to the PRC markets and not foreign stock exchanges for potential listings. We have already seen more interest in listings on the Chinese exchanges.
The revised rule goes beyond just increasing regulation of the companies that are currently seeking a red chip listing—it also affects the round-trip investment of special purpose vehicles through which Chinese companies may attempt such a listing at a later date. In the past, foreign investors have favored investing in special purpose vehicles alongside their Chinese counterparts. The MOFCOM approval now required for round-trip investments may make this process more difficult as it introduces additional compliance obligations for investors.
While the increased clarification on issues such as cross-border share swaps has been welcomed, the revised rule has also increased restrictions on foreign investment. This may lead to a subsequent cooling of certain pockets of the economy in the short term, not necessarily a bad thing in a strong market.
Balancing the development and growth of the Chinese economy with policies that keep the poor from falling further behind is essential to all who have an interest in China’s future. The elite may benefit from the implementation of the famous adage “to get rich is glorious,” often attributed to the late Premier Deng Xiaoping. However social and political stability are key ingredients in attracting foreign investment and protecting investments in the domestic market. The new M&A; rules and other changes in law sure to follow in the near future are important steps which signal the government’s proactive stance to manage China’s destiny.
Source: Business Law Today - Volume 16, Number 5 May/June 2007
