Making a strategic investment in a Chinese bank work

Author: | Published: 1 Jul 2005
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Strategic investment by foreign investors in Chinese banks requires time and effort, both before and long after the investment is made, to arrive at the outcome expected by all parties.

Corporate governance

Chinese banks are seeking ways to improve their corporate governance, starting by restructuring to become a company limited by shares, listing on the stock exchange and/or attracting foreign strategic investors. And of course problems can arise: for example, it was reported on May 27, a sub-branch of the Changsha Branch of China Construction Bank suffered the alleged theft of Rmb15 million by a low-level credit officer. Nasty surprises such as these are reason for pause, but should not alter the overall salutary trend of the inflow of strategic know-how. Combined with written policies and training in internal controls that are designed for absorption by Chinese masses, this know-how will be essential for ensuring that systemic problems do not occur in the large Chinese banks of the future.

Foreign strategic investors are willing to accept a minority stake in a Chinese bank as long as they can influence the corporate governance of the bank in ways that will make their investment pay off in the long run. This can be achieved through either affirmative or negative covenants. Affirmative covenants (agreements to do specific things) are most relevant in the context of business cooperation discussed below, in which the franchise of the foreign strategic investor remains undiluted and so a powerful bargaining chip regarding the Chinese bank. As a minority investor within the Chinese bank, the best way for the investor to influence the bank is through benefiting from negative covenants designed to restrict the way in which the bank might otherwise engage in its day-to-day operations.

A divide-and-conquer tactic is unwise for minority foreign strategic investors seeking to gain at least a plurality position. This is because the foreign strategic investor is, structurally, aligned on one side while its potential domestic passive partners are aligned as a group on the other side. It is probably necessary that the foreign investor win over, all or none, by continuous persuasion at the shareholder level, and let the chips fall where they may.

Chinese company law provides for specific, though not complete (from the viewpoint of a foreign strategic investor), protection against the oppression of minority shareholders. As Chinese legislation tends to follow the civil law tradition, there is some inertia regarding further expansion of rights contractually. Negotiating for additional protections, for example, through per se veto rights and supermajority provisions, requires delicate analysis of Chinese company law and bargaining with fellow shareholders, but unanimity requirements should not be suspect. In closely held institutions, they are feasible for fundamental transactions (for example, bankruptcy, merger/consolidation, substantial acquisition/disposition, extraordinary dividend, increase in authorized shares of any class, change in business or constitutional documents, change in auditor or accounting principles, and amendments to the shareholders' agreement).

The shareholder agreement can stipulate a lockup period and/or transfer restrictions applicable for all shareholders, to allow the foreign investor's investment to season. It can also stipulate risk management negative covenants that the bank, from the board of directors down, is obligated to observe in the course of fulfilling its duties to run the bank on a day-to-day basis in its best business judgment. These can take the form of restrictions and limits on, among others:

  • value at risk;
  • origination/underwriting and other commitments of balance sheet and/or reputation;
  • related party transactions;
  • other conflicts of interest (real or apparent);
  • asset-liability mismatches/bank liquidity at any given time;
  • new product approval;
  • client and transaction suitability thresholds/approval processes; and
  • communications with the public

If not specifically spelled out, a procedural mechanism for having such restrictions and limits constitutionalized can be set out in the agreement. The foreign strategic investor is well advised to have a controlling hand in/chair of the particular board committee responsible for this.

Business cooperation

This is where the bank and its domestic shareholders might have the greatest needs, and consequently where the foreign strategic investor might hold its strongest bargaining chip. This is also where the investor can negotiate, not in its capacity as minority shareholder, but in its capacity as a competitor and paragon. It is fairly obvious to the bank and the domestic shareholders that a foreign strategic investor will want access to customers (by virtue of the bank's customer lists and by acquiring a licence through association with the bank). It is also obvious that, in light of the limitations placed on majority rule under Corporate Governance above and the Financial Protections discussed below, the bank and domestic shareholders will expect the foreign strategic investor to make concessions as competitor and paragon. As competitor, the foreign strategic investor will need to negotiate carefully with respect to limitations on its ability to compete against (as opposed to cross-sell to) the bank's existing franchises in China, directly through whatever existing operations, business entities and relationships it might have onshore, and indirectly through stakes in other financial institutions in China. This might lead to the ultimate choice: (a minority stake in) the bank, or the foreign strategic investor's own branch network in China, but not both, which the foreign investor will vigorously resist.

As paragon, the foreign strategic investor will become engaged in a dialogue about contributing know-how that is relevant to the bank's target customers. Ultimately, the growth in value of the bank that is to be attributable to the foreign strategic investment transaction, and that measures the expectations of the other shareholders (who believe they are transferring value in the areas of goodwill, corporate governance and financial protections), will only be seen to be realizable through the foreign strategic investor's contribution.

As a result, the linchpin of the foreign strategic investment transaction and the pathway to achieving the foreign strategic investor's corporate governance, financial protection and domestic goodwill and customer access goals lies in its ability to market its know-how. The foreign strategic investor will argue that the bank's financial growth depends on it being able to run the bank rather than on the transfer of know-how, which carries the risk of unrequited love. The other parties will argue that there is no unrequited love, since the requiting was in the value given uniquely to the foreign strategic investor. If the negotiation, following conventional logic, then moves to the issue of how much know-how transfer is worth that value given, difficult and subjective issues arise.

Instead, this issue can be skirted, and the corporate governance, business cooperation and financial protection objectives of all parties can be harmonized, if the foreign strategic investor has done a good job at marketing its know-how without giving it away. In financial services, know-how resides in people and (particularly in trading and risk management disciplines) in IT. It is possible for good people to perform a number of banking operations without relying heavily on IT, but the converse proposition - relying solely on IT without discretionary oversight by good people - is illusory. This is an argument against making large IT transfers in and of themselves, but it leads to the next question: What is the formula for the people investment to be made?

The foreign strategic investor can run the bank in a real sense, provided that it is content to leave the shareholders and the board and its subcommittees to decide for themselves (apart from compliance with the negative covenants discussed above), in their best business judgment, whether the people installed ab initio (with all necessary corporate approvals within the bank) by the foreign investor in operating positions are worth retaining. By putting in place their best and brightest, foreign strategic investors show seriousness, the ability to manage risk and run sound treasury departments, and the prospect of leveraging the bank's existing customer list through the introduction of new products and service levels that they (the best and brightest), possibly with servicing from the foreign strategic investor entity, know how to manage and execute.

This would be no small investment (not a loan) of human capital. The foreign strategic investor that has the wherewithal as well as the conviction to take such a junior (that is, equity) position in the bank ultimately believes that:

  • its people can hold their own within, and even move, a potentially colossal employee body;
  • the residual financial return, for minority equity positions, generated through the collective efforts of its and existing personnel will be adequate reward;
  • it can harness the tension between reflexive shareholder democracy and short-term economic self-interest (on the part of other shareholders, its people and the people they train), on the one hand, and the proposition that everyone gains the most if its people are encouraged to embody its franchise within the Bank through their actions.

Like a long-term, strategic equity investor, there is a need to believe in the upside story because downside protections are not likely to be robust. Moreover, the investment's success is dependent on the investor identifying with the bank, rather than regarding the investment as just another portfolio investment (there is too much buy-side competition in China to make buying low, selling high a credible strategy). The type and quantity of human capital that is invested will depend on the nature of the bank and a consensus on what its target customers' product needs are. If the Bank is a greenfield start-up, the pro (from the foreign investor's perspective) of being able to identify more easily with the bank (and aligning, potentially, with its shareholders) must be balanced against the con of whether the bank has (or will have) the scale necessary to compete in the target market. If the bank is an existing institution with pre-existing shareholders, the investor must face a vastly greater inertia, and needs to decide whether it can apply its value-creating skill sets and leadership.

Financial protection

This consists of antidilution protection, event risk protection, and exit protection. Antidilution protection refers to the foreign investor's right to participate pro rata in all corporate and shareholder actions, including customary antidilution provisions in options or hybrid securities as well as preemptive and tagalong rights. Event risk protection refers to its right to participate in the upside of changes in law (for example, options contingent on changes in law permitting higher amounts of foreign ownership). Exit protection refers to its right to liquidate its position when certain events happen, for example, put rights in the event of breaches by the bank or other shareholders, and registration rights. The exercise price for a put will probably be a function of the initial purchase price of the stake to be put; this purchase price might have been without any block premium.

These are sensitive areas, for several reasons. First, there are issues of fairness and pricing among the various shareholders. How is the contribution of the foreign investor to be measured and, when added to the premium it pays (if any) for the various protections that take the form of unilateral options enjoyed only by it, does it suffice to justify the exercise price and term of the options? Second, optionality is a somewhat alien notion outside certain conventional areas such as insurance and commodity options. It is true that derivatives are no longer the taboo they once were in China, due to the CBRC's express recognition of bank participation in them. However, unlike swaps, forwards, futures and even convertible bonds, options qua options carry a greater speculative flavour for a number of reasons (wasting asset, leverage, pure dependency on volatility), and where the foreign investor is the beneficiary of a call or put while the bank/other shareholders are the writers of the call or put, the uncertainty of the pricing for the option exacerbates the feeling of unease about the bank's contingent liability.

Details, details

Successfully closing a strategic investment in a Chinese domestic bank is merely the start of the adventure. Good flight plans alone never ensured a safe landing. For example, the chairman of SDB found it necessary to intensely campaign and coordinate merely to put directors' liability insurance on the board meeting agenda. Such an event leads one to wonder about how much effort will be required in dealing with other matters relating to the corporate governance, risk management and day-to-day operation of the bank in practice.

Restrictions, limits and the embodiment of the franchise through the actions of the human capital contributed by the foreign strategic investor are necessary precursors to the type of new bank envisaged by the two sides and the Chinese banking regulators alike. However, the devil is in the details of what happens in the day-to-day interaction of the bank and the external world. The nightmare of all parties to the foreign strategic investment is waking up to headlines that some low-level employee in a remote branch engaged in misappropriation on a scale bad enough in itself and all the more frightening because it could be a hundred other employees in a hundred other branches. What is needed is a process - in writing - that is ingrained into the culture of the Bank.

Prosaic as it might sound, this process begins with documentation, including at least the following:

A bank-wide compliance manual, covering the gamut of internal behaviour norms: training, surveillance, KYC, money laundering and corrupt practices, appropriate transactions, sales practices, credit and commitments, trading and other limits, transaction recording and reporting, segregation, execution and settlement, separation of duties (the woe of financial institutions from Barings to the May 27 Changsha incident), incidents and exceptions, books and records requirements, follow-up, handling public communications, emails, and contingency planning.

Written policies for various committees (below the board committee level), which, for the sake of discussion, might include a credit and commitments committee, a new products committee, and an audit committee.

Customer and counterparty documentation (such as deposit and facility agreements; foreign exchange and derivatives agreements; and various agency and advisory and other services agreements) that protects the Bank while being compliant with applicable legal requirements and not the type of unbearably overreaching, foreign legalese contract that can undermine the sales force in the world's most populous market.

Checklists for deal origination and due diligence.

All of these need to be written for Chinese officers and employees - they need not be bespoke, but the templates that work in other jurisdictions will require vetting for Chinese legal and, more importantly, client and employee purposes.

The spate of betrothals and marriages between foreign strategic investors and the Chinese domestic banks/other shareholders has just started. Like all betrotheds and newlyweds, they have a long way to go after signing the pre-nup.

Author biographies

Fred Chang

King & Wood

Fred Chang, a partner in the banking and international financial services group since February 2004, has specialized in financial transactions involving financial intermediaries since graduating from Columbia Law School in 1986. Before King & Wood, Chang worked at Debevoise & Plimpton, Goldman Sachs and Deutsche Bank as its Asia general counsel, and has also served as chair of ISDA's legal and regulatory committee in HK. At King & Wood, Chang concentrates on transactions that separate assets from the credit risk of fundraisers as much as possible, as well as M&A involving domestic financial institutions.

Wang Ling

King & Wood

Wang Ling, co-head of the banking and international financial service group, specializes in banking, international finance, project finance, aircraft and equipment financial leasing, and foreign direct investment in China. Wang has represented well-known banks and multinational corporations in their various transactions, including general banking, syndicated loans, export credit, standard documentation, project finance, aircraft leasing, and investment in Chinese financial institutions.

Her recent projects include: advising IFC on its acquisition of a minority stake in Minsheng Bank, advising Beijing Bank in the strategic investment in Beijing Bank by foreign investors, and advising Ford in the establishment of Ford Auto Finance Company in China.