by Michael Chen
Traditionally, foreign enterprises may invest in China in one of two ways: they may either make a “green field” investment by building its own business from scratch, or they may acquire ownership interest and assume some level of management control of an existing Chinese legal entity.
In recent years, with wider and deeper penetration of foreign investment into Chinese economy, we have seen an increased number of acquisitions of Chinese companies by foreign enterprises. In 2001, 2.7 billion USD was invested in China through acquisition; while 13.2 billion USD was invested in China through acquisition in the year 2005, which accounts for 21.5% of total foreign direct investment made in the year 2005.
The new regulation, which is a joint effort by the Ministry of Commerce (MOC), State Owned Assets Supervision and Administration Commission of the State Council (SASAC), State Administration of Taxation (SAT), State Administration of Industry and Commerce (SAIC), China Security Regulatory Commission (SCRC), and State Administration of Foreign Exchange (SAFE), was published on August 8, 2006 and will go into effect on September 8, 2006.
Comparing with an earlier interim version, which was published in January, 2003 and was in effect since April, 2003, the new regulation is significantly more sophisticated and detailed. Among others, the following are a few highlights of the new regulations:
Being jealous of the preferential treatments offered by Chinese government to foreign investment, Chinese domestic legal entities have set up shams-- wholly owned foreign enterprises (WFOE) or joint ventures (JV) to take advantage of these preferential treatments. Some of the preferential treatments that are available exclusively to foreign investment include lower income tax rates, tax holidays, and better treatment by the government in general. It can be achieved by setting up a holding company in Hong Kong, the Cayman Islands, or in the British Virgin Islands where the maintenance of the corporate formality is inexpensive and the tax and foreign currency regulations are very flexible or nonexistent. After the establishment of the offshore company, the Chinese incorporators (either natural persons or legal entities) will set up an offshore bank account and deposit foreign currencies accumulated from its international trade or otherwise acquired from markets where RMB (the Chinese currency) can be freely exchanged into its offshore account. Through its offshore company and its offshore bank account, the foreign currency will be invested in the WFOE and JV to meet the capitalization requirements. By doing so, a WFOE or JV is successfully established without any infusion of foreign capital. It is estimated that about one third of foreign direct investment was such disguised domestic investment.
The new regulation imposes a greater reporting obligation upon both the domestic company, which is the target of the acquisition, and the foreign company that will acquire the domestic company. The regulation introduces the concept of “actual control” as the guideline to discern between “true” foreign acquisition and “disguised” foreign acquisition. Under the new regulation, if the domestic company to be acquired and the acquiring foreign company are under the common control, the transaction may be approved but the post acquisition legal entity will not enjoy the preferential treatments otherwise available.
Another interesting aspect of the regulation is that it adopts the principle “substance over form,” which is quite unusual for regulations of this kind in Chinese legal system to determine whether the two companies are under common control.
Instead of cash, foreign acquiring companies may use certain qualified foreign securities as the consideration to acquire Chinese domestic companies. However, the securities must be issued by a public company which is incorporated into a jurisdiction with a comprehensive corporation legal system, (Cayman Islands or BVI may not suffice) and the issuer and its directors and officers have no record of security law violation in the past three years.
When foreign securities are used, rather than cash as the consideration, the parties to the transaction have a higher level of obligation to produce more due diligence documents and third party report to prove the proposed transaction is fair, safe, and feasible under both Chinese legal system and the relevant foreign legal systems.
A noteworthy practice adopted by the new regulation is that the government realizes that a “share swap” transaction may be lengthy and uncertain. Therefore, it provides the mechanism of “conditional or advanced approval” by issuing an approval investment certificate and business license with an eight months lifespan. The conditional approval certificate and license will either be converted into a regular certificate and license or expire.
Prior to the enactment of this regulation, Chinese company’s overseas listings and the capitalization of the offshore shell issuers operated under the condition without regulatory guidance. Consequently, most offshore listings were carried out with little transparency and the Chinese government was deprived of the opportunity to know what was really happening in these transactions.
The new regulation allows the establishment of a Special Purpose Vehicle as the vehicle for domestic companies to utilize for its offshore listing transaction. Once the SPV is established in a foreign jurisdiction and approved by the relevant Chinese government agency, the domestic acquisition target can obtain a conditional investment approval certificate and a business license with a life span of fourteen months. Therefore, the offshore SPV is no longer an empty shell but owns the Chinese entity with substantive operation and assets. The conditional investment approval certificate and business license will either expire, should the offshore listing fails, or be converted into a regular investment approval certificate and a business license.
The government, of course, will collect information regarding the substance of the transaction and will also monitor and direct the flow of the proceeds of the offshore listing.
Similar to the Hart-Scott-Rodino (HSR) Antitrust Improvement Act of 1976, the new regulation addresses potential antitrust concerns raised by transnational acquisitions.
Under the new regulation, when the acquiring foreign entity is of certain size and has sufficient market share in China, (the market scope itself is not defined) any proposed acquisition must be approved by the MOC and SAIC. On its own motion or brought by interested third parties, MOC and SAIC may conduct a hearing to determine whether the proposed transaction may raise antitrust concern or otherwise adversely affect free competition.
A very interesting point of the new regulation is that Chinese government may conduct a hearing and approve or disapprove a proposed merger or acquisition OUTSIDE the territory of China as long as it has an anti-competition effect within China. This is a rare incident of the exercise of extraterritorial regulatory power by the Chinese government.
Learning from the block of the acquisition of Unocal by the U.S. Congress, the new regulation gives the MOC the power to examine and invalidate any acquisition that may adversely affect national security, important industries, or acquisition of Chinese legal entities who own famous or historical trademarks. (Here goes the Beijing duck restaurant.)
If you would like more information about the new regulations for acquisition of Chinese companies by foreign enterprises, please contact Michael Chen at mchen@kmclaw.com or 801.328.3600.