MERGERS & ACQUISITIONS
Update: In China, Mergers and Acquisitions Get Tougher
September 27, 2006
Deborah Levenson

Companies considering mergers and acquisitions "will have to allow more time and less flexibility in setting price," says Sommers. ARTICLE TOOLS Print Version Reprints RECENT ARTICLES China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance RMB roams the region

Doing business in China has always been an exercise in fortitude, but acquiring one of its companies has become even more difficult, thanks to newly updated merger and acquisition regulations that took effect in September.

The regulations "give and they take away" from foreign investors, according to Amy Sommers of the Beijing office of Squire, Sanders & Dempsey L.L.P. and co-chair of the American Bar Association"s China Committee. They give a brand-new opportunity for companies to use shares to reduce the cash needed to acquire a Chinese company, according to Sommers and other attorneys - as well new layers of necessary government approvals for deals. They take away a considerable degree of flexibility from foreign investors, attorneys say.

Many of the newly required government approvals apply to scenarios in which foreign and Chinese partners form an entity in another country-such as the Cayman Islands-and have that entity then set up a wholly foreign-owned enterprise (WFOE) in China that can take advantage of tax advantages afforded foreign investment enterprises (FIEs). The updated regulations regulate these "roundtrip" investments strictly, explicitly, and in new ways, according to Grace Fremlin, partner in the Washington, DC office of Steptoe & Johnson LLP.

These changes, plus new antitrust scrutiny and attention to possible risks to national economic security "have the potential to make the approval process longer and less certain," says Michael Burke, associate in the international section of Williams Mullen in Washington, D.C. and co-chair of the American Bar Association's China Committee.

Share Exchanges Confer Benefit, but Also Added Costs and Hurdles

The regulations generally limit share exchanges to sizeable, well-established publicly traded foreign companies, attorneys say.

According to a summary prepared by Squire Sanders, such investor companies must be listed in an overseas public stock exchange market with a mature securities exchange system. While Sommers notes the regulations favor very large companies on the scale of Johnson & Johnson or General Electric, Fremlin notes they permit such deals for medium-sized foreign companies - defined at worth of $50 million to $4 billion.

Stipulations regarding securities exchange systems bar use of shares from tax havens like the British Virgin Islands and Cayman Islands, says Owen Nee, senior corporate counsel in the New York and Hong Kong offices of Orrick, Herrington & Sutcliffe LLP. But a company formed in one of those jurisdictions could be capitalized with shares of its parent company and then use those listed shares to pay the acquisition price, he believes.

Stock exchanges reduce the cash required to acquire a Chinese company, but can actually increase deal costs, Fremlin points out. One such added cost is fees for a consultant who has registered with the Chinese government to issue a due diligence report on the foreign investor.

"The goal is to make sure that the buyer is worth what it says it is," Burke postulates. While U.S. companies are already accustomed to inquiries about a target's books, being the subject of such scrutiny is new and potentially uncomfortable.

Local Chinese nationals will best fill the role of consultant, say Sommers and Burke. She predicts that a company's Chinese legal advisors will identify firms that provide consultants. She likens the process of finding and hiring them to locating the appropriate people to appraise state-owned assets.

Share exchange transactions must be completed in about six months, and require approval of the Ministry of Commerce, rather than its local counterpart. The ministry will approve an approval certificate valid for only six months after issuing the new business license for the domestic company, regulations say.

In addition, the domestic company must go through an approval and registration process because it now holds shares in a foreign entity, a situation the regulations identify as a type of overseas investment. Failure to complete this process will render the approval certificate void, according to the Squire Sanders summary.

A Longer Journey for "Roundtrip Investments"

Provisions governing these investments are considered the most important in the regulation by some U.S.-based attorneys.

"Roundtripping" refers to setting up offshore companies as foreign investment enterprises (FIEs) and using them to acquire state-owned companies and take advantage tax benefits given to foreigners. The process is popular with Chinese parties looking to avoid taxes and foreigners looking to acquire -- without setting up joint ventures -- state-owned companies in sectors restricted to Chinese citizens.

The regulations are intended to stem the flow of capital out of China and to better determine the true value of companies created via this route, Burke and Sommers say. The provisions also reflect the government's desire to avoid impermanent business structures in certain sectors, Burke adds.

Roundtrip investment provisions emphasize that parties to a deal cannot evade requirements through FIE, according to the Squire Sanders summary. If a Chinese company becomes a foreign investment enterprise via a roundtrip investment scenario, it doesn"t enjoy certain benefits usually afforded FIEs, such as a two-year tax exemption. "This provision is designed to limit sham foreign investment," the summary states.

The old regulation required "roundtrip" approval only from the State Administration of Foreign Exchange. Updated regulations now stipulate that the Ministry of Commerce, not its local counterpart, must grant approval of an offshore company owned or controlled by Chinese parties, according to Squire Sanders. Additionally, partners must seek approval before Chinese parties set up and offshore company or acquire a domestic company.

U.S. participating in roundtrip investment scenarios must make sure Chinese owners have proper approvals for using the structure and additional approvals for the listing of special purpose vehicle shares, Fremlin points out.

The regulation does include an exception offering FIE tax benefits if a roundtrip deal increases the target company"s registered capital level and the offshore company subscribes to purchase equity that"s more than 25% of the increased registered capital of the Chinese company. The exception also applies when the offshore company is a joint venture having certain foreign investors who ultimately own more than 25% of the domestic company, according to the Squire Sanders summary.

Antitrust Provisions Precede New Law

Sommers and Burke call the regulation"s antitrust provisions "strange," given a major new antitrust law - expected to take effect soon - will set up a new government agency to handle monopoly issues.

But Fremlin points out that the forthcoming antitrust law "will be really broad, covering a variety of topics like price fixing and conspiracy," and that the provisions in updated regulation address just acquisitions.

Burke says say the inclusion of the antitrust provisions in the regulation may be the government"s response to growing public resentment of foreigners taking over their brands. "The Chinese systems is communist and opened up to foreigners only in the last 25 years or so. There"s still lots of unease about foreign investment," he says.

Many attorneys and experts on China believe the antitrust provisions are a specific response to the stalled deal between the U.S. venture capital company The Carlyle Group and Xugong Construction Machinery. In October 2005, Carlyle agreed to pay $375 million in a deal that Sommers says would make Carlyle the single largest foreign investor in China.

Fremlin says the deal ran into difficulty because the topic of negative press reports that highlighted the potential concentration of power. She thinks the government chose the updated merger and acquisition regulation as an interim vehicle for addressing public fears.

Whatever the government's motives for including antitrust provisions in the updated regulations, they are rife with potential for confusion and overlapping jurisdiction, Sommers says.

The antitrust provisions allow competitors to request an antitrust exam by the State Administration of Industry and Commerce and the Ministry of Commerce. Investors must report to these government agencies when:

• Either party in a deal gains revenue in the Chinese market totaling more than RMB 1.5 billion in the current year,
  
• The buyer acquired more than ten Chinese companies in related industries within a year,
  
• Either party has more than 20% of market share in China, and
  
• The deal will give one of the parties market share of more than 25% in China.

A requirement to report to relevant government agencies before publishing overseas merger plans kicks in if:

• One of the parties own assets of more than RMB 3 billion in China or gains revenue of more than RMB 1.5 billion in the current year,
  
• One party and its related companies own market share of more than 20% in China,
  
• The deal will result in market share of more than 25% in China for any one party, or
  
• One party, as a result of the deal, will own equity in more than 15 FIEs in "relevant" industries in China.

Requirement for National Economic Security Exam

Another new Ministry of Commerce reporting requirement kicks in when a deal would transfer of actual control of a domestic company owning famous trademarks, traditional Chinese trade names, important industries or factors that could potentially affect national economic security. But the provision, according to Burke, doesn"t define what constitutes trademarks and names at issue.

The regulation doesn't specify whether the ministry must actually approve the deal or if merely informing the ministry is enough, according to the Squire Sanders summary. It adds that failure to report by either party and significant effect on national economic security may spur the ministry to terminate the transaction.

Dealing With the Regulation

Companies considering mergers and acquisitions "will have to allow more time and less flexibility in setting price," says Sommers. "And to the extent they"re doing roundtrip deals . . . that will be harder. For middle market medium-sized companies, things just got more complex and expensive."

Fremlin agrees. The new law has thrown up substantial new regulatory hurdles for both publicly traded and privately held companies in the U.S. and elsewhere, she says. However, the hurdles aren"t all bad, Fremlin says. They underscore senior management's "need to make a decision on acquisition in China for sound business reasons," she says. "Perhaps those business reasons for a acquisition now need to be more compelling than before."

Acquisition of a domestic Chinese company is just one way to enter or expand in China, Fremlin points out. The updated regulation applies only to acquisition of domestic companies and has no relevance to new investments and establishment of new operation joint ventures or FIEs, she adds.

"It has no relevance to an acquisition of an FIE and there are hundreds of thousands of FIEs in China that are potential acquisition targets," Fremlin adds.

See also: Legal Compliance: Structuring Mergers in China

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