Red tape casts shadow on cross-border M&A

Author: | Published: 1 Jul 2005
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The growth of the Chinese economy and its integration into the global economy continues to drive cross-border M&A transactions at an unprecedented rate. China now sees around 200 M&A deals a year, as multinational companies view expansion of their businesses into China through M&A a main strategy, international financial investors continue their focus on various emerging sectors in China and the Chinese government continues its efforts to reform and revitalize state-owned enterprises. Cross-border M&A is often considered an effective way to enter into sectors that have been closed to foreign participation until recently. Many also eye the targets that can provide a cost-effective manufacturing and supply base in China while cutting off a supply base to a global competitor and turning a competitor in China into a positive number on their own financial statements. The fast-growing private sector in a wide range of industries is also eager for capital that is often not available from Chinese banks or the stock market. This demand for capital has fuelled private equity investment in China.

2003 was a year of regulatory development. The Ministry of Commerce (MOFCOM), the State Administration of Taxation, the State Administration of Industry and Commerce and the State Administration of Foreign Exchange (SAFE) jointly promulgated the Provisional Rules on Mergers with and Acquisitions of Domestic Enterprises by Foreign Investors (the Inbound M&A Rules), which for the first time specifically set out a legal framework for inbound acquisitions and contemplate unprecedented transaction structures in China, such as share swap. Though the Inbound M&A Rules contain various restrictive provisions, overall their promulgation is a positive development. In another development in 2003, the China Securities Regulatory Commission (CSRC) abolished the requirement that Chinese companies wishing to go public in international capital markets be subject to a process that is equivalent to CSRC's review and approval. This has removed a barrier to the much-needed exit that international financial investors view as a must for their inbound acquisitions in China.

Not surprisingly, with such regulatory sanction and clarity, cross-border M&A transactions in 2004 and 2005 have intensified and transaction structures diversified. The positive market and regulatory development, coupled with the hopes that foreign exchange control will loosen (or even that the renminbi will eventually be convertible) and that government approval processes will become simpler, have created a bullish market sentiment.

Yet, amid this sentiment, the State Development and Reform Commission (SDRC) and SAFE issued a series of rules and notices in late 2004 and early 2005 that seem to have cast a shadow on at least the immediate future prospect of cross-border M&A transactions and venture capital investment and to have created additional regulatory hurdles.

From SDRC: The verification requirement

On July 25 2004, the State Council issued the State Council Decision Concerning the Reform of System of Investment. Following the State Council Decision, SDRC issued the Provisional Administrative Measures concerning Verification of Foreign Investment Projects (the SDRC Inbound Investment Verification Measures) on October 9 2004. Under the State Council Decision and SDRC Inbound Investment Verification Measures, foreign investment projects involving fixed-assets investment are now subject to verification by SDRC or its local counterpart. Specifically, any fixed-assets foreign investment project within an encouraged or permitted category with total investment of more than $100 million or within a restricted category with total investment of more than $50 million must be verified by SDRC. SDRC's local counterpart must verify any fixed-assets foreign investment project with the total investment below these thresholds. This verification process also applies to projects involving a change of shareholder or equity ownership resulting in a conversion of a domestic entity into a foreign-invested enterprise (FIE). Subsequently, MOFCOM and its local counterparts have adjusted aspects of the traditional approval process and, with this adjustment, any foreign investment project in an encouraged or permitted category with total investment of more than $100 million or within a restricted category with total investment of more than $50 million is subject to approval by MOFCOM; and any foreign investment project with the total investment below these thresholds is subject to approval by MOFCOM's local counterpart.

Verification requirement a double-edged sword

The new SDRC verification process and the adoption by MOFCOM and its local counterparts in practice of certain aspects of the SDRC Inbound Investment Verification Measures are a double-edged sword for foreign strategic and financial investors eager to enter into or expand in China through cross-border M&A transactions and anxiously waiting for greater flexibility and efficiency in the government approval process. On the positive side, MOFCOM's local counterpart can now approve more transactions, because most transactions are still below $100 million and fall into an encouraged or permitted category.

This positive development, unfortunately, does not come without a price. One drawback of the system is that any transaction in excess of $100 million is now subject to MOFCOM's approval, regardless of whether it falls within encouraged category. This departs from the past practice whereby MOFCOM's local counterpart had the authority to approve encouraged projects of any size, if certain conditions were met. Another complication is that SDRC's verification, a process reflecting SDRC's exertion of authority and power in the foreign investment area, now requires a foreign investor to take one additional step directly, that is, obtaining verification from SDRC or its local counterpart in a project involving fixed-assets investment. This is unlike the traditional approval process whereby SDRC and its local counterpart generally stayed behind the scenes and foreign companies would, for the most part, simply submit their transaction approval application documents to MOFCOM or its local counterpart, which would then coordinate and consult with SDRC or its local counterpart. For example, today an M&A transaction involving a new FIE (for example, an asset deal where a new FIE is established to be the acquirer) or purchase of equity from an existing shareholder of a domestic company would require verification by SDRC or its local counterpart.

The verification requirement creates regulatory uncertainty to M&A transactions in many respects. The exact scope of its application is unclear. For example, it should apply only to fixed-assets investment, which could be narrowly interpreted to mean only projects involving new construction or broadly interpreted to include all projects other than those in service industry. Even then, there could still be confusion. For example, is a logistics service project subject to the verification process when the project is in service, but an applicant plans to construct new warehouses? In a cross-border M&A transaction, for example, a simple acquisition of equity interest of a domestic company, confusion abounds as to whether it involves fixed-assets investment and is subject to the verification process. Not surprisingly, opinions and interpretations of SDRC's local counterparts at different provinces, and of SDRC and MOFCOM, diverge. Also, in the context of a cross-border M&A transaction, whether the deal size or the total investment of the project should be used to determine the level of verification required is also an interesting issue. Several SDRC's local counterparts say that the deal size should be referenced. This is contrary to the Inbound M&A Rules issued by MOFCOM jointly with several other ministerial level government authorities, where the amount of total investment is referenced in determining the level of approval.

Aside from these technical issues, an even more significant complication is the turf war between MOFCOM and its local counterparts, on the one hand, and SDRC and its local counterparts, on the other. Several local counterparts of SDRC (for example, Jiangsu province, Beijing) have started implementing the SDRC Inbound Investment Verification Measures while many others, ignoring the verification process, continue the traditional approval practices. This could leave foreign investors feeling uneasy, fearing that their projects would not be considered fully approved if they do not receive the verification certificate. Indeed, if the State Council Decision and the SDRC Inbound Investment Verification Measures are strictly enforced, the consequence of failure to comply with the verification requirement could be grave, as the land, state administration for industry and commerce, customs, tax and foreign exchange authorities are directed not to issue relevant certificates, licences and registrations necessary for an FIE's operations. Lastly, a series of ambiguous and subjective verification standards - such as projects conforming with public interest and state anti-monopoly rules, and long- and medium-term national economic and social development - give SDRC discretion in deciding whether to grant its verification or not. One cannot help but wonder whether SDRC, a central government authority historically in favour of more conservative economic policy, would use the verification process to protect domestic industry.

Outbound investment verification requirement

SDRC also extended its authority and power to outbound investment by promulgating the Provisional Administrative Measures concerning Verification of Outbound Investment (the SDRC Outbound Investment Verification Measures) on October 9 2004. This verification is in addition to the approval of MOFCOM or its local counterpart of outbound investment, which has long been required. Under the SDRC Outbound Investment Verification Measures, any outbound investment by a domestic entity of more than $10 million in areas other than exploration of natural resources is subject to verification by SDRC, whereas any outbound investment of the same nature below $10 million by a domestic entity is subject to verification by SDRC's local counterpart. This verification requirement has particular implications for cross-border M&A transactions where a foreign transaction party and a domestic entity would prefer to use an offshore vehicle through which to own a domestic operating company. To accomplish this, a domestic entity must effect a pre-investment reorganization whereby the domestic entity might have to first fund the offshore vehicle to acquire the target business in China. This funding, regardless of the amount, which in practice would be no less than the net asset value, would now be subject to verification by SDRC or its local counterpart.

From SAFE: the new approval/verification and registration requirement

Besides the new layer of regulatory oversight, that is, verification added by SDRC, the Notice on Issues Relating to Improving Foreign Exchange Management in Mergers and Acquisitions involving Foreign Investors (Notice 11) issued by SAFE on January 21 2005 and the Notice on Issues Relating to Registration by Domestic Residents of Offshore Investment and Registration of Mergers and Acquisition involving Foreign Investors issued by SAFE on April 8 2005 (Notice 29) sent a shock wave to private enterprises and entrepreneurs eager for international venture capital investment and to foreign private equity funds looking for attractive projects and returns. These notices put a hold on many other cross-border M&A transactions and cast a shadow on many deals that were closed long ago.

Life before Notice 11 and Notice 29

In recent years, it has been common in private equity transactions and some of the strategic investments in Chinese privately owned companies that investors would structure deals with domestic entrepreneurs through the use of an offshore special purpose vehicle that would in turn own and control an operating wholly foreign-owned enterprise in China. This structure is preferred for a variety of reasons - the desire by investors for a more flexible, familiar and predictable legal system, the need for easier exit by venture capital investors, and the enjoyment of more advantageous tax treatment, to name a few. This structure would typically involve several steps: organization by domestic entrepreneurs of an offshore special purpose vehicle; acquisition by the special purpose vehicle of the operating business in China; and, lastly, investment by investors in the offshore special purpose vehicle. The requirement in the Inbound M&A Rules prohibiting equity or assets to be transferred at obviously lower than the value determined through a mandatory appraisal process has already created a regulatory hurdle, that is, domestic entrepreneurs and investors would have to find ways to first fund the pre-investment reorganization at not an obviously too low price. The Notice 11 and Notice 29, issued by SAFE to combat against the embezzlement of state-owned assets, control capital out-flow and ensure balanced foreign exchange, created yet another barrier to cross-border M&A and private equity transactions, particularly those involving emerging private sectors in China.

Life after Notice 11 and Notice 29

Notice 11 and Notice 29 contain the following principal requirements.

First, a domestic resident must obtain approval from, and register with, SAFE in accordance with the Measures on Foreign Exchange Management for Overseas Investments issued by SAFE in 1989 (the FX Measures) and a series of implementation rules and notices, before they can directly or indirectly set up or control an offshore entity. So domestic residents now need to disclose and submit evidence of their sources of foreign exchange to SAFE's local branch. There does not seem to be any monetary threshold on when this approval and registration is required. Technically, using even a de minimis amount of funds to pay for shares at a nominal value would be subject to approval by, and registration with, SAFE. Another ambiguity is that the term domestic resident is not defined in either Notice 11 or Notice 29. Using the definition of this term provided in other regulations, domestic residents could include not only Chinese citizens but also foreign nationals with a domicile in China or foreign nationals living in China for over a year.

Second, a domestic resident must obtain verification from SAFE when they transfer domestic assets or equity in exchange for equity in an offshore entity or other forms of offshore property rights. This means that, if a domestic resident uses onshore assets or equity instead of remitting or using foreign exchange offshore to set up an offshore entity, they would still need to obtain verification from SAFE.

Third, when an offshore entity acquires a domestic entity where the offshore entity is set up or controlled by a domestic resident or where the offshore entity and the domestic entity are both managed by a domestic resident, then approval from SAFE must be obtained for the acquisition. If the domestic entity is already an FIE, approval from SAFE is still required when the Chinese party is transferring its equity to an offshore entity as long as a domestic resident relates to the offshore entity and FIE in the same way as described above. This is a critical requirement. It would subject the pre-investment reorganization mentioned above to SAFE's approval if domestic entrepreneurs set up or control the offshore entity or manage both the offshore entity and the domestic entity. Even if one could forgo the typical pre-investment reorganization and instead, foreign investors unrelated to domestic entrepreneurs set up and control an offshore entity through which to invest in a domestic entity and convert it into an FIE, this requirement could still apply when one day domestic residents cause and fund the transfer of the equity interest owned indirectly by them in the FIE to the offshore entity in exchange for equity interest in the offshore entity, unless the funding for the transfer and the management structure of the FIE and the offshore entity are structured carefully to avoid control by domestic residents of the offshore entity or share of management between the FIE and the offshore entity by domestic residents. This alternative structure poses additional transaction risks and would seem to be possible only if domestic entrepreneurs take a minority position and non-managerial role, which is unlikely in many venture capital transactions. Even then, the funding itself is still likely to be subject to registration or approval/verification under either or both of the first two requirements in Notice 11 and Notice 29 set out above.

Another uncertainty is that neither Notice 11 nor Notice 29 sets out SAFE's approval or verification criteria. Indeed, the approval under the first requirement and the verification under the second requirement lack transparent criteria or standards. The practice of SAFE and its local branches to date is to put all applications on hold.

Lastly, the timing of the SAFE approval can be problematic for transaction parties. It appears that SAFE's approval procedure would take place through a domestic operating entity's foreign exchange registration process after MOFCOM or its local counterpart approves the acquisition or investment itself. This raises an interesting issue and creates an additional transaction uncertainty - what if parties to an M&A transaction have obtained MOFCOM approval and SDRC verification only to find that the domestic operating entity cannot obtain foreign exchange registration?

Fourth, these requirements apply not only to future transactions but also to transactions that occurred before January 24 2005, the date on which Notice 11 was issued. Technically, these requirements apply to all arrangements where offshore entities were set up by domestic residents to acquire domestic operating companies or where offshore entities and domestic operating entities are affiliated by virtue of common management by domestic residents. Operating entities in China are prohibited from remitting profit and capital to their offshore parent companies if domestic residents fail to comply with these requirements. On the part of domestic residents, the consequence of registration would be to open aspects of their financial dealings and offshore interests, a scenario that many would like to avoid.

What does the future hold?

SDRC's verification requirement and SAFE's approval, verification and registration requirements have added additional complexity and unpredictability to an approval system that is complicated but tested and predictable. Today, if, for example, a domestic entrepreneur who owns a furniture production business in China with a net asset value of $11 million and a foreign strategic partner who runs an extensive furniture distribution network in the US wish to merge their businesses under an offshore entity in a tax advantageous jurisdiction, into which another foreign financial investor would also invest to fund the expansion of furniture production in China, a series of approval, verification and registration would await them. The domestic entrepreneur (or their domestic company) would probably need to obtain SDRC's verification, MOFCOM's approval and SAFE's approval and registration to set up an offshore entity that would be used to take over and eventually hold the furniture production business. When the offshore entity takes over the furniture production business and makes additional investment to fund the expansion of the furniture production business, SDRC's verification requirement applicable to inbound foreign investment would apply in addition to the traditional approval from MOFCOM or its local counterpart under the Inbound M&A Rules. After the verification by SDRC (or its local counterpart) and approval by MOFCOM (or its local counterpart), the resulting FIE would then need to obtain SAFE's approval to obtain foreign exchange registration. At the time this article was written, SDRC, SAFE and even MOFCOM might not be prepared to grant some of these approvals, verifications or registrations, leaving the transaction parties and their advisors pondering other transaction structures.

It is reported that SAFE is working together with MOFCOM to refine the requirements provided in Notice 11 and Notice 29 to avoid or reduce its stifling effect on much-needed foreign investment. It is also reported that MOFCOM will soon be ready to promulgate its regulations concerning share swaps between domestic and offshore entities. Share swaps, if permitted, would greatly increase the flexibility of transaction structures and allow greater freedom of flow of capital across the border. Lastly, it is hoped that, with time and practice, SDRC's inbound investment verification system will be predictable, fair and efficient.

Author biography

Yingxi Fu-Tomlinson

Kaye Scholer LLP

Yingxi Fu-Tomlinson is a partner resident in the Shanghai office of Kaye Scholer LLP. Born and raised in Shanghai, she is among the first small group of individuals to have received formal legal education both in China and in the US in the 1980s. She has been practising in the areas of corporate finance and M&A for 17 years, of which seven were in the US and 10 are in the greater China region. She advises international strategic and financial investors on numerous strategic investment, acquisition, restructuring, joint venture and private equity projects in China in a wide range of industries. Yingxi Fu-Tomlinson was featured in the November 2000 issue of The American Lawyer and was identified by the Leading Lawyers Survey conducted annually by Asia Law & Practice as one of Asia's leading business lawyers in the areas of M&A and restructuring from 2001 through 2005. She writes and speaks frequently on PRC law matters, including co-authoring chapter 15, titled "Duties and Liabilities of Directors and Managers", of the multi-volume treatise Doing Business in China (Juris Publishing).