Tradelink-eBiz : e-Post - Foreign Capital For Mergers and Acquisitions: Support or Restrict?

Undoubtedly, the Regulation on Mergers and Acquisitions of Domestic Enterprises by Foreign Capital (hereinafter referred to as "the Regulation"), which was jointly promulgated by six government departments of the People's Republic of China ("PRC") and took effect on 8 September 2006, brings a cool breeze to the prosperous Merger and Acquisitions ("M&A") market in Mainland China. In light of the Regulation, the ambitious M&A operators may have to withdraw what seemed to be a "perfect" plan at the time, and plan all over again.

Standardizing forms of M&A, and means of payment

The Regulation validates M&A by assets purchase or share transfer, namely, foreign investors may purchase PRC domestic assets for setting up a new enterprise, or they can sell the shares of their own company in consideration of shares in a PRC domestic enterprise. They may also obtain shares of a domestic enterprise by increasing the share capital or a purchase of the registered capital.

As to the means of payment, it is mandatory that payment should be made in cash for domestic assets acquisition, while the shares of a domestic enterprise can be purchased by cash or by means of share swaps.
Foreign capital in an M&A should comply with the PRC domestic foreign investment management system

The Regulation emphasizes that an M&A involving foreign capital should strictly comply with the requirements of the "Catalogue for the Encouragement of Foreign Investment Industries". Foreign capital is not permitted to enter into fields which are restricted or prohibited by means of an M&A. In fact, certain additional administrative approval procedures are applicable to some fields. For example, an acquisition related to the transfer of a famous trademark in Mainland China or a traditional Chinese brand shall be subject to the approval of Ministry of Commerce of the PRC. In the absence of proper anti-monopoly regulations in Mainland China, anti-monopoly review procedures are carried out by the Ministry of Commerce whereas the State Administration for Industry and Commerce of the PRC is established to supervise whether the actions of an M&A would lead to any market monopolization, or materially damage fair competition in the Mainland China market. Furthermore, domestic enterprises which are being merged or a quired should ensure that capital injections are made within specified timeframes (not exceeding a year) and notify and complete the change formalities with the government's administrative organizations, including the Industry and Commerce Administration Bureau, Taxation Bureau, Foreign Currency Management Bureau and so on, within the prescribed time limit.
Express provision of conditions and procedures on foreign capital related M&A

The Regulation provides the conditions and reporting procedures for an M&A. It also validates the legitimacy of offshore companies which are commonly used for an M&A. However, a "Special Purpose Vehicle", which is defined as an overseas company set up by a domestic company for the purpose of reinvesting in the Mainland in order to enjoy favorable foreign investment policies, is restricted by the new approval procedure.
Intermediary consulting organizations as independent third party to bear risks

The Regulation stipulates due diligence investigation as part of the legal procedures for an M&A for the first time. It is mandatory for a Chinese registered intermediary organization to act as a consultant to conduct asset valuation with an aim to prevent improper transactions and loss of state-owned assets.

Foreign investors should reconsider the feasibility of setting up "Special Purpose Vehicles" with domestic enterprises for the purpose of an M&A in Mainland China.
The PRC government's supervision on foreign capital investment is strengthened. The relevant authorities may reject an M&A more flexibly, for example, the deal may affect national economic security. The authorities can even terminate the ongoing projects which have not been reported and approved. Further, the Regulation expressly forbids setting the consideration for share transfer or acquisition of capital excessively lower than the assessed value. Under such circumstances, the flexibility in consideration negotiation is somewhat hindered.
The Regulation provides that an M&A shall not damage the interest of any third party. Thus, the arrangement for employees of an acquired enterprise, as well as the debts disposal plan, may increase the cost of acquisition to some extent.
It has now become more difficult for foreign investors to expand in the Mainland China market to achieve monopolization.

Retroactivity

Generally, laws and regulations are not retrospective for the purpose of maintaining economic orders. However, under Article 4 of the Regulation, a company will be required to make relevant adjustments if after M&A, its scope of business is not in compliance with the requirements of relevant foreign investment policies. However, the problem is that the Regulation did not provide a clear timetable for implementing the necessary adjustment.
Conflict with the Company Law of the PRC

Under the Company Law of the PRC, shareholders can enter into an agreement so that dividends are not distributed in proportion with the relevant capital investment. However, under Article 16 of the Regulation, dividend shall be distributed in proportion to actual capital contribution before the consideration of acquisition is paid. Such differences in regulations are bound to cause confusion in actual practice.

All in all, the Regulation has expanded from 26 articles in the provisional rules to 61 articles organized in five chapters. The Regulation brings legal certainty to foreign capital related M&A. Although investment plans or strategies may need to be reconsidered or adjusted, in the long run, it is still favorable to the order and operation of foreign capital M&A market in Mainland China.