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New Regulation on Foreign Investment into China
On 8 August 2006, six PRC authorities jointly issued the "Rules on Acquisition and Merger of Domestic Enterprises by Foreign Investors" ("Order No.10"). It provides clarifications to the Provisional Rules issued in 2003 and further regulates the requirements and procedures on the acquisition and merger of PRC domestic enterprises by foreign investors. This circular will become effective on 8 September 2006.
Background
The issuance of Order No.10 is not surprising to most foreign investors. By providing more regulatory channels for M&A activities in China, it echoes Circular Huifa [2005] No.75 issued by the State Administration of Foreign Exchange ("SAFE") last year, which governs the foreign exchange control on financing and repatriation investment of offshore Special Purpose Vehicles ("SPVs").
The Order indicates the determination of the PRC authorities, headed by the Ministry of Commerce ("MOFCOM"), to strive for a healthy balance of business development in China. By introducing the new M&A rules, PRC authorities would like to improve the M&A regulatory environment and encourage foreign investment as well as outbound investment of domestic enterprise. On the other hand, the authorities also aim to protect China's local industry development and prevent expatriation of strategic assets, which include both state-owned and privately owned tangible and intangible properties.
Changes Highlights
I. Prevention of Chinese assets expatriation
- Cross-border share swap as a form of payment
Order No.10 is the first PRC regulation legally endorses and sets out the regulatory framework for cross-border share swap as a form of payment for foreign investors to acquire shares of domestic enterprises. Given the Order provides a breakthrough to the form of considerations for M&A exercise in China, it is expected that more varieties of foreign investment would be introduced to encourage foreign investments.
- Due diligence review on foreign investors
In case of share swap acquisition, domestic enterprises must engage an M&A advisor to perform a due diligence review on the foreign investor. The M&A advisor, which should be a reputable agency registered in China, has to issue a report to set out its professional opinion on the financial status of the foreign investor. The regulation is believed to aim to prevent overseas shell SPVs from acquiring Chinese assets and to avoid sale of Chinese assets at below market price.
- Regulations on SPVs
Within 30 days of completing the overseas listing of its SPVs and the underlying Chinese assets, domestic enterprises are required to submit a report on the listing and a plan of proceeds repatriation to MOFCOM and SAFE respectively. Order No.10 further defines the establishment and roles of SPVs during the M&A exercise, which supplements the requirements in Huifa [2005] No.75. Proceeds repatriation can be in the forms of:
(a) providing commercial loans to domestic enterprises;
(b) setting up new Foreign Invested Enterprises ("FIEs") in China; or
(c) acquiring shares of domestic enterprises.
II. Tightened control on anti-monopoly transactions
Order No.10 emphasizes the importance of state economic security. It requires that if an acquisition either (1) involves strategic important industries; (2) has or may have impact on state economic safety; or (3) causes a transfer of actual controlling rights of a domestic enterprise which owns well-known trademarks or Chinese traditional brand names, the transaction must be reported to the MOFCOM. MOFCOM could deem the transaction invalid either if the relevant parties fail to report the transaction or they consider the transaction places material impact on state economic safety. Other than such reporting requirements, majority of the requirements regarding anti-monopoly, including approving standard and exemption conditions, as stated in the Provisional Rules in 2003 remain unchanged.
III. Quasi-FIEs
- Clarification on the criteria to be a genuine FIE
To tackle the increasing use of quasi-FIE (e.g. a domestic enterprise to set up an offshore SPV to acquire its own shares), Order No.10 specifically excludes these entities to qualify as FIEs. However, in certain cases, these SPV could still be qualified as FIEs (e.g. if the foreign capital is over 25%) and be entitled to the benefits and responsibilities as a FIE.
- Disclosure of Quasi-FIEs
If the PRC enterprise or individual sets up an offshore SPV to acquire a related enterprise in the PRC thereby converting it to a FIE, the transaction is required to be approved by MOFCOM. Order No.10 also requires the parties to the transaction to disclose their relationship, if any. They should notify MOFCOM if their ultimate controlling party is the same and need to explain whether their valuation of the acquisition is determined on an arm's length basis. The parties cannot use trust, holding on behalf and any other structures to avoid the above requirements.
Order No.10 provides a more mature platform to regulate M&A activities in China, particularly for the prevention of Chinese asset expatriation, anti-monopoly review and quasi-FIEs. The PRC authorities aim to maintain a healthy balance between encouraging foreign investments and preventing under-priced disposal of PRC assets to foreign competitors. There is also a conscious decision to postpone the effective date of Order No.10 in order not to jeopardise the progress of existing M&A deals. Though their intention is not to hinder the investment environment in China, foreign investors have to be very sensitive to the authorities' main concerns when negotiating deals in the PRC. |
