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Statistics released by MOFCOM indicate that for the first 8 months of 2003, China approved 28,748 new foreign investment enterprises, up by 11.73% on a year-on-year basis, with total commitment reaching US$93.792 billion and actual utilization of US$43.559 billion, up by 38.89% and 18.77% respectively on a year-on-year basis. By the end of August 2004, China cumulatively approved the establishment of 494,025 foreign investment enterprises with a total commitment of US$1.036921 trillion and actual use of foreign investment of US$545.029 billion.
Over the past few years, multinational manufacturers have expanded production within China, aiming to streamline costs, increase profit margins and expand into one of the world's fastest-growing consumer markets.
There have always been legal issues for foreign investors to overcome. Until recently China had no systematic law on mergers and acquisitions. There were limited provisions in Chinese company law, contract law and various administrative regulations and notices, but the classic route for foreign investors was to establish an equity joint venture, a co-operative joint venture or a wholly foreign-owned enterprise.
Now, the legal climate has changed. Beijing has issued M&A-related regulations including the Provisional Regulations on Reforming State Owned Enterprises with Foreign Investment (effective January 2003), the Provisional Regulations on Foreign Investors Merging with and Acquiring Domestic Enterprises (effective April 2003) and the Provisional Regulations on Transfer of State Ownership of Chinese Enterprises (effective February 2004).
These rules increase disclosure, transparency and certainty in the M&A regulatory regime and seek to ensure that state assets are not sold or transferred at below what the PRC Government regards as their proper value. They make it possible for mergers and acquisitions to be structured with more certainty. These regulations provide foreign investors with broader opportunities to acquire shares in State-owned enterprises and domestic enterprises and to acquire legal person shares of listed companies.
Instead of launching start-ups, many foreign investors are now considering acquisitions, while traditional joint ventures are increasingly rejected in favour of majority shareholdings, if not full ownership. As well as low labour costs, foreign investors are placing greater emphasis on goodwill, supply of raw materials and the distribution networks, all of which enable them to lift market share more quickly.
2. PRC Government Policy
Current PRC government policy indicates strong support for the mergers and acquisitions market.
At the same time, PRC Government policy is also to step up the privatisation of the State-owned sector, an example is the recent announcement of the restructuring of State assets of 117 State-owned enterprises totalling RMB 22.7 billion through M&A in Changchun, the capital of northeast China's Jilin province.
China's integration into the world economy has already accelerated upon WTO entry. To meet the challenges of WTO entry, China is readjusting its foreign investment policies, shifting the emphasis from traditional joint and cooperative ventures to transnational purchases.
II. Common Types of Mergers and Acquisitions in China
1. Direct Equity Acquisition
A foreign investor may purchase all or part of the non-listed equity interest of a target company direct from one or more of the existing investors. Alternatively, the foreign investor can subscribe for increased capital of a target company. Unlike an asset acquisition, the foreign investor cannot specifically select its preferred assets and businesses of the target company.
Direct acquisitions are subject to the approval of the Chinese authorities. This method tends to be the preferred sale method for PRC State vendors as they thereby divest themselves of the liabilities as well as the assets of the enterprise being sold.
2. Indirect Acquisitions
A foreign investor can acquire or increase control a target company by purchasing offshore some or all of the shares held by the target company's foreign parent(s). However, this type of acquisition is only available if the PRC target company has foreign investors' equity.
As the transaction can be completed entirely offshore, it does not require approval of the PRC authorities. Also, from a PRC regulatory point of view, it is not necessary to obtain consent from any other partners of the PRC target company or from the board of directors of the PRC target company.
3. Asset Acquisition
A foreign investor can use a newly established foreign invested enterprise or an existing foreign invested enterprise as an acquiring vehicle to purchase directly some or all of the business and assets of a target company. A definite advantage of asset acquisitions is that a foreign investor can select its preferred assets and businesses of the target company. Therefore, generally, any existing obligations, liabilities or restrictions of the target company will remain the responsibility of the target company.
The foreign investor must establish a registered presence in China in the form of a foreign invested enterprise to acquire and operate domestic assets. Separate approval from the PRC authorities is required for a new foreign invested enterprise which is established for the purpose of acquiring the assets of the PRC target company.
4. Acquisition of Corporation with State-owned Interests
Interests in State-owned enterprises in China can be acquired by direct equity acquisition or by the asset acquisition mentioned above. Certain special regulations govern acquisitions of State-owned interests, in particular the State-owned Enterprise Restructuring Regulations (effective from 1 January 2003) and the Provisional Regulations on Transfer of State ownership of Chinese Enterprises (effective from 1 February 2004), together with the Provisional Regulations on the Merger and Acquisition of Domestic Enterprises (effective from 12 April 2003).
III. Laws and Regulations of Mergers and Acquisitions in China
There are two important regulations governing the acquisition of assets and shares of State-owned enterprises and wider general regulations on mergers and acquisitions by foreign investors in China:
1. Provisional Regulations on the Merger and Acquisition of Domestic Enterprises (“M&A Rules”)
On 7 March 2003, the PRC Ministry of Foreign Trade and Economic Cooperation (“MOFTEC”), the State Administration of Taxation (“SAT”), the State Administration of Industry and Commerce (“SAIC”) and the State Administration of Foreign Exchange (“SAFE”) jointly issued the Provisional Regulations on Foreign Investors Merging with and Acquiring Domestic Enterprises (the “M&A Rules”), which became effective on 12 April 2003. The M&A Rules are the first comprehensive regulations aimed at making all types of mergers and acquisitions involving foreign investment subject to consistent standards and represent another step toward the overall modernization and rationalization of China's foreign investment laws and regulations.
This is one of the most important regulations in relation to mergers and acquisitions by foreign investors in China. The key features of the M&A Rules are:
Article 2 of the M&A Rules provides that they are applicable to acquisitions of domestic PRC enterprises without foreign investment by foreign investors. They apply to:
(a) Share Acquisitions
(i) acquisition, by agreement, of equity in a domestic company and its conversion into a foreign invested enterprise; or
(ii) subscription of additional registered capital in a domestic company and its conversion into a foreign invested enterprise.
(b) Asset Acquisition
(i) establishment of a new foreign invested enterprise and its acquisition, by agreement, of the assets of a domestic company; or
(ii) acquisition of assets in a domestic company by a foreign investor by agreement and injection of those assets as registered capital into a foreign invested enterprise.
MOFCOM's view is that the M&A Rules apply to any target company established as a company under PRC Company Law. Therefore, they apply to limited liability companies and companies limited by shares, including State-owned enterprises organized as limited liability companies and companies limited by shares.
(B) Foreign Investors Qualifications
The M&A Rules do not replace any existing foreign investment laws and regulations, but rather provide guidance and implementation mechanics. As is the case with other foreign investment laws and regulations, as an overriding condition, all foreign investments must follow the Foreign Investment Industry Guidelines ("Industry Guidelines") which delineate the categories of encouraged, permitted, restricted and prohibited industries for foreign investment. An enterprise engaged in an “encouraged” business, for example, may qualify for local (and generally more lenient) approval processes. The M&A Rules are no exception, which means that no acquisitions are allowed if the target is in a prohibited category and no acquisition of a controlling interest is allowed if the target is in a restricted category where the Chinese parties must have the controlling interest.
(C) A New Type of Foreign Invested Enterprise
Foreign investment of less than 25% in a company is permitted for all transactions covered by the M&A Rules. Article 5 of the M&A Rules states that in the event a foreign investor's contribution falls below 25%, this will be noted on the approval certificate and business licence of the foreign invested enterprise. Such type of foreign invested enterprise would not be able to take advantage of any preferential treatment available to a foreign invested enterprise with 25% or more foreign investment.
(D) Asset Appraisal
The M&A Rules provide that the acquisition price must be based on an asset appraisal and that transactions involving state-owned equity interests or assets must comply with special regulations on the management of state-owned assets. Reflecting the government's sensitivity to tax evasion, the dissipation of assets at below fair value and the use of M&A transactions to move assets offshore, the rules expressly prohibit setting an acquisition price significantly below the appraised value of the assets to be sold. Within these boundaries, existing laws and regulations generally allow the parties to freely negotiate the transfer price, which means the parties could effect a share or asset transfer at a very low price if this was supported by an appraisal. Also, there are separate regulations governing the disposal assets of state-owned interests.
Under the M&A Rules, a domestic appraiser must be used. However what often happens is that a foreign investor will also appoint its own appraiser to provide benchmark for the value of the assets and to assist in the negotiations with the domestic valuer.
(E) Creditors' Rights
Under the M&A Rules, a disposal of shares does not affect the creditors rights of a domestic enterprise. Debts and creditors' rights remain with the enterprise after conversion to a foreign invested enterprise. On the other hand, the selling domestic enterprise retains its debts and creditors' rights under an asset purchase transaction.
The parties to the transaction, creditors and other unspecified parties can enter into separate contractual arrangements regarding the disposition of the obligations and creditors' rights of the merged or acquired domestic enterprise.
(F) Payment of Consideration
The general rule for purchases of equity or of assets is that the purchaser must pay the seller within three months after issuance of the business licence of the foreign invested enterprise created as a result of the equity or asset purchase transaction. However, an extension may be granted with approval, so that 60% is payable within six months after issuance of the business licence, and the full amount within one year.
In the case of an equity merger or acquisition leading to an increase of the registered capital of the resulting foreign invested enterprise, if the joint venture agreement or articles of association of such foreign invested enterprise provide for a one-time payment, the investor must make payment in full within six months of the new business licence; if payment in installments is provided, the investor must pay at least 15% of the full subscription price in the first installment and pay the remainder in full within three months of the new business licence.
(G) Registered Capital Share
In the case of an acquisition of equity interests from existing domestic shareholders, the registered capital of the resulting foreign invested enterprise shall be the same as that of the original domestic entity. On the other hand, if a foreign investor subscribing for the increased portion of registered capital of the resulting foreign invested enterprise, the registered capital of the resulting foreign invested enterprise will be the sum of the original registered capital and the newly subscribed capital and the relative ownership percentages between the foreign investor and the existing domestic shareholders will be negotiated between the parties based on the appraised value of the assets of the original domestic entity.
(H) Ratios Between Registered Capital And Total Investment
The Regulations also set forth the following upper limits for total capital based on the registered capital of the resulting foreign invested enterprise in the case of a share acquisition or subscription:
(i) if registered capital is US$2.1 million or less, the total amount of investment shall not exceed 10/7 of registered capital;
(ii) if registered capital is greater than US$2.1 million and not greater than US$5 million, the total amount of investment shall not exceed two times registered capital;
(iii) if registered capital is greater than US$5 million but not greater than US$12 million, the total amount of investment shall not exceed 2.5 times the registered capital; and
(iv) if registered capital is greater than US$12 million, the total amount of investment shall not exceed three times the registered capital.