A hot topic in China is the so-called diversification of capital of state-owned enterprises (SOEs). This is nothing more than a politically correct euphemism for privatisation. It essentially means that the Chinese government is looking to put for sale signs on state-owned enterprises (SOEs) all across China.

The State-owned Assets Supervision and Administration Commission (SASAC) was established in 2003 to act as the direct owner and administrator of SOEs across China. At the time it was set up, central SASAC was responsible for nearly 200 large-scale central-level SOEs. According to recently announced plans, SASAC intends to cut that number to fewer than 100 central-level SOEs and to require all remaining central-level SOEs to spin off all non-core assets. Each of the central-level SOEs has hundreds and sometimes thousands of direct and indirect subsidiaries, and below the central level, at the provincial and municipal levels, there are tens of thousands of local-level SOEs. That adds up to a lot of potential targets for private investors.

Capital diversification takes many different forms. In the days following the economic opening up of China, state assets were commonly contributed into greenfield Sino-foreign joint ventures in an early form of asset acquisition.

Next came domestic and off-shore IPOs, but the public float was typically limited to 20-30% of the total share capital, and until recently the remaining state-owned shares in listed companies were classified as non-tradable legal person shares. Following recent share reforms for A-share companies in China, these so-called G-shares have been converted into restricted tradable shares which can be sold down in stages over a three-year period in a controlled lock-up arrangement. Local SASACs are now pushing their better SOEs to go public in no small part in order to be able to achieve liquidity of government investments through the public stock markets.

The other key trend in the sale of state-owned assets is M&A activity, both domestic and cross-border, with share acquisitions now more popular than the old-style asset deal. While there are numerous hoops that foreign acquirers must jump through to get a cross-border deal done, in-bound M&A is quickly becoming the preferred investment vehicle for foreign players in China.

Commendably, China has been quite keen to avoid the whole-sale illicit transfer of valuable state assets into private hands as has happened in Russia and and other economies in transition. From the early stages of economic reform, independent valuations of state-owned assets were required before transfers could take place. In the last few years, this requirement has been buttressed by the adoption of a public auction process through the state-owned asset property rights exchanges (PREs).

Corruption and inefficiency

Predictably, in practice, the state-asset valuation and PRE processes do not work as well as one would hope. In most cases it ends up being a lot of work for the parties without affecting the fundamental terms of legitimate transactions involving state assets, but in other cases the system is still subject to corrupt influences that subvert the very purpose of the state asset valuation and public auction system.

A wide range of transactions trigger the valuation requirement: conversion of an SOE into a limited liability company or joint stock limited company; injection of state assets as in-kind capital contributions; merger, acquisition, division, bankruptcy or dissolution of SOE; changes in shareholding percentages in a non-listed SOE; transfer of equity interests or shares in non-listed SOEs; transfers, swaps and auctions of state-owned assets; leases of state-owned assets to non-SOEs; disposal of state assets in satisfaction of judgment or determination of value of state assets involved in litigation; and others. The above apply not only to pure SOEs but any entity in which there is any direct or indirect state ownership, including Sino-foreign joint ventures in which an SOE or SASAC holds a direct or indirect equity interest.

Under the relevant regulations, the basic process is as follows: the proposed transferor in a transaction involving state assets engages a licensed valuation company and the valuation company conducts valuation and issues the report. Although four valuation methodologies are recognised under the relevant regulations (discounted earnings method, replacement cost method, current market price method and liquidation price method), in most cases local valuers will reflexively resort to some variation of the net asset value (NAV) or net book value (NBV) method.

Prior to the introduction of the PREs, so long as the price to be paid was not less than 90% of the statutory valuation result, the transaction could proceed. With the advent of the PREs, the statutory valuation is announced and in theory potential bidders have at least 20 days to indicate an interest. If there is only one potential bidder, or with special approval from SASAC (which typically is not available as a practical matter), the parties can enter into a private agreement on the terms of the transfer subject to the above 90% rule. If there is more than one potential bidder, then a public auction has to be conducted, and the winning bidder enters into a contract for the transfer of the state-owned equity interests or assets. The PRE issues a certificate which is then presented to the local bureau of the Ministry of Commerce (Mofcom) as part of the package of application documents for approval to complete the transaction.

Chinese pragmatism

Of course, it never works this way in the real world, and Chinese pragmatism wins out in almost every instance. Take the example of the purchase by a foreign company of shares in a non-listed SOE. In practice the parties would agree the consideration for the shares up front, and then the SOE seller would engage the licensed valuation company. The foreign buyer does not sit passively to the side hoping for a favourable valuation result but actively works with the valuation firm to make sure the correct (read "pre-agreed") result is achieved.

In many cases it will be necessary to work with the valuation firm to agree on the valuation methodology and the assumptions to be input into the model in order to ensure that the valuation result falls within the desired parameters. To be safe, the foreign buyer arranges for a draft report to be issued first to make sure the local valuation firm has not inadvertently (or worse yet, intentionally, and possibly at the insistence of the seller who is suffering seller's remorse and wants to reopen the price negotiations) departed from the prepared script. In these cases, more heavy lifting is required to push the valuation firm to revise the draft report until the right result is achieved. Then the final report is submitted and the parties proceed as agreed.

In other cases, the Chinese seller simply gives the statutory valuation firm the target number, and this figure magically appears in the valuation report. Either way, the valuation process is almost never independent or disinterested.

The PRE process is similarly managed by the parties, generally with the active assistance of the PRE authorities. The parties come to the PRE with their agreed deal and conforming statutory valuation report, and the PRE in most cases then posts the deal in a manner which will ensure that there are no competing bids, typically either by means of bidder qualification requirements that only the intended buyer can satisfy or by posting the deal information in a manner which cannot be accessed in a timely manner by other member of the public as a practical matter. Then the parties proceed with the negotiated deal as previously agreed.

It is not quite as painless as the foregoing description may suggest. There are additional application documents to be completed and application fees to be paid. Most PREs will have a standard form agreement that they will insist be used as a base for the transfer contract. As one would suspect, this standard form of agreement is poorly drafted, incomplete and generally useless. Some PREs are more flexible than others, but in some cases you have no choice but to use the standard form provided by the PRE and then append the real contract as an annex to the standard contract in the form of supplemental terms and provide that in case of conflict, the supplemental terms control, thereby eviscerating the whole of the standard form contract. This is inelegant but it works.

The Shanghai PRE, the Shanghai United Assets and Equity Exchange (SUAEE), has a well-deserved reputation for being the most rigid and most expensive PRE in China. In a recent transaction, the prospective transferor, a municipal-level SASAC entity from a regional province, engaged SUAEE to conduct an international competitive bid auction for a minority stake in a leading SOE directly held by the local SASAC entity. This was not a typical transaction in that there was no pre-negotiated deal, but it was a true competitive bid auction. The seller had selected SUAEE in the belief that SUAEE would be able to conduct the auction process in a more independent and professional manner, and the seller (as well as the bidders) paid a very substantial fee for the privilege. When the auction process elicited only two bids, both of which were seriously non-conforming due to the highly non-commercial and inflexible terms in the SUAEE standard contract, the seller simply discarded the SUAEE process and negotiated directly with the preferred bidder using the bidder's form of agreement. When the regional SASAC had a subsequent deal to go through a PRE, it selected a different regional PRE that was both less expensive and more flexible.

This example points up a few key lessons. First, not all PREs are created equal. Some are more flexible than others. Second, parties have a choice of PREs, so shop around. And third, if SASAC wants the deal bad enough, they can control the PRE process to achieve the outcome they want. This means that buyers should not always take the printed instructions and terms issued by the PRE at face value. If the SOE seller and SASAC are on side, then the PRE generally will have to fall in line eventually, even if the process is painful and time-consuming for both buyer and seller.

The darker side

Although in the typical scenario the PRE process is benignly frustrating, in some cases, more commonly in connection with transactions involving private domestic players, a darker side to the PRE process emerges. A core element of the biggest corruption scandal in China in recent memory involved apparent corrupt abuse of the state asset public auction system. In September 2006 Liangyu Chen, the Secretary of the Chinese Communist Party (CCP) Shanghai Municipal Committee, member of the CCP Central Committee and the highest ranking Party official in Shanghai, was detained for investigation of misuse of funds, corruption, and other violations of party discipline. Several other high ranking officials in Shanghai were also arrested in connection with the arrest of Mr. Chen.

Also caught in the widely cast net of this corruption probe were certain board members and senior executives of Shanghai Electric Group Company Limited (SEC Group) and its controlling shareholder Shanghai Electric Corporation (SEC). Other companies controlled by some of these officers and directors had benefited from illicit loans from the Shanghai Municipal Social Welfare Fund controlled by Mr. Chen.

The reason that SEC and SEC Group were dragged into this scandal apparently arose from the fact that companies owned by these directors had obtained their shares in SEC and later SEC Group through a rigged public auction process conducted by the Shanghai PRE. Although the entities controlled by these directors were newly established, under-capitalized, small-scale private enterprises, they emerged as three of only five successful bidders from among more than 100 interested parties in connection with the auction of just over 30% of the shares in SEC in March of 2004. Many smelled a rat at the time, and last year the trap was finally set and sprung.

The moral of the story is that the state asset transfer system is almost always rigged. The good news is that for the most part it is rigged in a manner which achieves an arms length market price in connection with otherwise legitimate transactions. The bad news is that this pragmatic good result comes at an otherwise unnecessary cost of additional time, process aggravation and professional fees. The key is to know the game and play it as cleanly as possible to achieve the right result with as little aggravation as possible.

By Robert Lewis of Lovells, Beijing