Silk Road Communications - China M&A Issues

In late 2002 and early 2003, the Chinese government issued several rules and regulations on mergers and acquisitions by foreign companies in China (the “M&A Rules”). The M&A Rules provide much broader opportunities for foreign investments in China, which, for the past twenty years, have been confined to the forms of a direct investment, such as a joint venture or a wholly owned foreign subsidiary.

For people who are not familiar with the Chinese economic structure, the M&A Rules may appear a little confusing, as the Chinese government issued some of these rules to address state-owned entities while others were meant for foreign investors. To a certain extent some of these rules overlap. The purpose of this article is to set out a quick roadmap to the Chinese M&A Rules.

To understand the Chinese M&A Rules, one needs to understand the following two basic principles:

1. Investment Guidelines. All foreign investment in China, whether direct foreign investment or investment through a merger or acquisition transaction, is subject to industry policies embodied in the “Guidelines on Foreign Investment Directions” (the “Investment Guidelines”) issued jointly by four major Chinese national governmental agencies. The Investment Guidelines divide all industries into four categories: encouraged, permitted, restricted and prohibited. The Investment Guidelines provide a catalogue that contains detailed lists of different industrial sectors within each category. If there is a restriction on foreign ownership interest in any specific industrial sector, the catalogue will specify the maximum percentage permitted for foreign ownership interest in the sector. The Investment Guidelines and its catalogue are generally user friendly.

2. Governmental Approval. By the same token, all foreign investment in China, whether direct investment or investment through a merger or acquisition transaction, is subject to governmental approvals. The general rules are that an investment of US$30 million or above is subject to the approval of the Ministry of Commerce (or even by the State Council), and a foreign investment below that threshold will be approved by the local branch of the Ministry of Commerce. There are some exceptions to this general rule; for example, a special economic zone may have authority to approve a larger project than a local government.

With these two principles in mind, we may walk through the Chinese M&A Rules in two different scenarios: publicly listed companies and non-publicly listed companies.

Currently, two types of shares are traded on a Chinese stock market: A-shares and B-shares. A-shares are shares denominated in the Chinese currency while B-shares are shares denominated in a foreign currency. Only a small number of listed companies in China have been approved to issue B-shares. A-shares can be divided into traded and non-traded A-Shares. Traded A-shares account only for a small percentage of all issued and outstanding A-Shares of a listed company.

Any foreign investor may freely purchase and sell B-shares, but only certain “qualified foreign institutional investors” (“QFII”), such as investment banks, insurance companies, etc., may purchase and sell traded A-shares on a stock market. However, there are some limitations, for example, a QFII may not hold more than 10% of traded A-shares of any listed company. In addition, a listed company may not have more than 20% of its traded A-shares to be held by multiple QFIIs as a whole.

Non-traded A-Shares are legally called “state shares” and “legal person shares”, which refer to the shares issued by a listed company and held by the state itself or by a state owned entity. For a long time, foreign investors were not permitted to acquire state shares or legal person shares. The M&A Rules provide that a foreign investor may either acquire state shares or legal person shares from the holders of such shares by itself or acquire state shares or legal person shares through a joint venture or a wholly owned subsidiary set up by a foreign investor. A foreign investor may not transfer any state shares or legal person shares to a third party within 12 months after it has paid the full share price. In addition, any transfer of state shares or legal person shares by a foreign investor is subject to the approval of the relevant governmental authority.

Under the M&A Rules, a foreign investor may acquire an ownership interest in a non-listed Chinese company by either purchasing the equity interest from an owner or from a shareholder of the Chinese company or by contributing additional capital to the domestic company. A foreign investor may also purchase assets of a domestic company through its existing or a newly formed joint venture or wholly owned subsidiary in China. If a foreign investor decides to set up a new entity (either a joint venture or a wholly owned subsidiary) in China to acquire assets from a non-listed Chinese company, the foreign investor may use the assets to be purchased from the Chinese company as its capital contribution to its newly formed entity in China.

For many years, non-performing debt owed by stated owned entities has been a major problem facing Chinese banks. The Chinese government has taken several measures to resolve this problem. For example, the Chinese government has permitted Chinese banks to convert their non-performing loans into the equity of the debtors. It has also sold non-performing loans to certain Chinese asset management companies or to major foreign investment banks. Consistent with these measures, the M&A Rules specifically provide that a foreign investor may acquire rights from a Chinese bank, as a creditor, and convert the creditor’s right into equity.

A mandatory procedure for an asset purchase transaction involving a state owned company is the Assets Evaluation Procedure. However, this procedure is not a new requirement. It has been applied to the formation of joint ventures between a foreign investor and a state-owned entity if either the foreign investor or the Chinese party contributes assets to the joint venture, instead of or in addition to cash.

The M&A Rules involve many other China-investment issues, such as the legal status of a foreign investment enterprise and taxation. Further, the M&A Rules have many loopholes and ambiguities. In future articles I will discuss the finer points of the M&A Rules and how they may affect your investment in China.

[1] This article is an abstract of a more detailed article by May Y. Hao on the same subject. For a full version of this article, please visit the website of MayGlobe Law Firm at http://www.mayglobelaw.com.

[1] May Y. Hao owns and operates the law firm, MayGlobe Law Firm, which provides legal services to companies involved in China-related transactions. Ms. Hao received the Master of Laws degree from China University of Political Science & Law in Beijing in 1988 and a JD degree from Northwestern University School of Law in 1993. After graduation from Northwestern, she practiced law with three leading US law firms, White & Case, Baker & McKenzie and Mayer, Brown, Rowe & Maw. (She can be reached at 312-255-0589, or mhao@mayglobelaw.com. Website address: http://www.mayglobelaw.com.