China's New M&A Regulation and Its Impacts on Foreign Business

a. The acquisition may result in transfer of the actual controlling rights of the PRC domestic companies owning any famous trademarks or traditional Chinese brands to the foreign company;

b. Such acquisition involves any major industry; or

c. The acquisition has or may have an impact on the state economy security. (Article 12).

This clause empowers MOFCOM together with other authorities to enjoin and reverse an acquisition that fails to do the above required report and may cause impact on the state economic security.

New qualification for the FIE Treatment.

New Regulation requires the ratio of foreign investment in FIE to exceed 25% of the registered capital of the FIE established by the foreign acquisition in order to qualify for enjoyment of the preferential treatment of FIE and administrative procedure for borrowing loans by FIEs. (Article 9)

Share Swaps ' Equity Payment-based Acquisition of Domestic Companies by Foreign Investors.

The 2003 Old Regulation first allowed share swaps in the acquisition by foreign investors in China but did not have any specific rules implementing it. The New Regulation promulgated detailed and restricted guidelines for foreign investors involved in the share swap acquisition to follow, including:

a. The foreign company involved in the transaction should be in compliance with all the requirements on its lawful establishment, the place of its registration must have a complete corporate legal system and free from the punishments from supervision agencies for the past 3 years;

b. The equity interests are not subject to any dispute of ownership or any lien or otherwise encumbrances;

c. The equity share for the foreign company has to be lawfully listed for public trade on the overseas securities exchange market excluding any sale-counter trade market; and

d. The trading price of the overseas company's equity shares has been stable for the recent one year. (Articles 27 through 38)

The above detailed provisions are aimed at giving more options for foreign companies in China for the payments of the acquisition, which can be considered as a positive step for China in introducing international M&A norms and encouraging more foreign investments.

For the first time, the New Regulation requires the domestic company or its shareholders to employ a registered agency in China as its acquisition consultant to conduct due diligence with regard to the truthfulness of the application documents and the overseas company's financial status required for the purpose of such acquisition. (Articles 30 and 31)

New Regulation and Its Impact on
Foreign Companies' Penetration in China Market

The New Regulation contains no defined terms on some important matters, such as definitions, factors or criteria used to determine:

a. 'Major industries', 'impact on the state economy security' and 'China's famous trademarks or traditional Chinese brands,' which are required to get approval from MOFCOM as mentioned in Article 12.

b. 'Large market share and other important factors that would materially affect market competition' as mentioned in Article 51; and

c. 'Improvement and the conditions for fair market competition,' 'advance technology and management talent,' which are qualified for exemption from examination under antitrust provision as mentioned in Article 54.

The above undefined terms give MOFCOM and other government authorities more discretion, power and leverage for deciding whether to approve or deny the foreign investor's acquisition, thus creating uncertainties and more risks for foreign investors to acquire the Chinese domestic companies. As China remains a country with a planned economy, this is nothing novel to foreign investors. The difference possibly resulting from this new rule may be that China becomes more serious and aggressive in carrying out the rule in restricting foreign investors' takeover of Chinese domestic companies for the purpose of market entry and Chinese domestic companies can use this rule to block foreign companies' acquisition of their competitors to avoid competition in the domestic market. It is important to note, though, that whenever there is uncertainty embedded in a government policy, creative strategies can be developed to obtain the required authorization.

With its accumulating and increasing knowledge in western countries' practice in promulgating laws and regulations, China may introduce more international practice in protecting its domestic industries while technically adhering to the market access schedule it has undertaken as a WTO member. As Vice Prime Minister Wu Yi addressed 160 multi-national business executives in Xiamen during China 10^th International Fair for Investment and Trade on Sept. 7, 2006, one day before the adopting of the New Regulation, China continues to promote foreign investment in the fields of agriculture, service industries and traditional manufacturing, research and development centers, new high-technology industries, advanced manufacturing, and the energy conservation and environment sectors. A strategy for focusing on these areas and using well-connected consulting, PR, legal and accounting firms with a good government affairs program in China is critical to help to smooth the process.

On Aug. 8, 2006, China released a new rule of 'Provisions on Acquisition of Domestic Enterprises By Foreign Investors' (New Regulation), with the joint efforts of six People's Republic of China (PRC) regulatory authorities including the Ministry of Commerce (MOFCOM), the State-owned Assets Supervision and Administration Commission (SASAC), the State Administration of Taxation (SAT), the State Administration for Industry and Commerce (SAIC), the China Securities Regulatory Commission (CSRC) and the State Administration of Foreign Exchange (SAFE). The New Regulation took effect on Sept. 8, 2006, and invalidated the 'Interim Provisions on Acquisition of Domestic Enterprises By Foreign Investors' (Old Regulation) issued on March 7, 2003. The New Regulation has drawn speculations that China is changing its policy toward foreign investors' acquisitions of its domestic companies and tightening its restrictions on foreign investments.

This article presents the background that gave rise to this new regulatory scheme and provides a comparative analysis of the two regulations, with a particular focus on how foreign companies doing business in China will be impacted.

Background

First, since China's entry into WTO, there is significant growth in the foreign investors' takeover of PRC domestic companies in China. Even prior to its entry into the WTO, China has been the largest recipient of foreign investment among developing countries for the past 15 years, reaching a record 60 billion US dollars in 2004. With China opening its markets to foreign business pursuant to its WTO commitments, foreign companies have increasingly converted their Joint Ventures (JV) into Wholly Foreign Owned Enterprise (WFOE) by acquiring either their existing Chinese JV partners or other PRC domestic leading companies in order to deepen their penetration in the China market. According to the report of the Development Research Center under the State Council of PRC, foreign investors today control the top five businesses in each of the industrial sectors that are open to foreign investors, and in 21 out of 28 leading industrial sectors in China most assets are now controlled by foreign investors. In 2005, the nationwide debate over 'malicious mergers' of Xugong Group Construction Machinery, China's largest construction machinery manufacturer and distributor, by Carlyle Group, a global private equity firm, stirred nationalism and serious concern over the disappearance of national brand names of some industries in China and loss of state-owned assets. Leading industrial organizations and business communities urged that a new rule regulating foreign investors' acquisitions of Chinese companies be put in place.

Second, with China's increasing foreign currency reserves reaching 875.1 billion US dollars in March 2006 and the Chinese government's policy to encourage domestic companies to 'go global,' more and more successful Chinese companies have begun to acquire foreign companies to gain access to overseas markets. However, their strategy has had its complications. For the largest Chinese electronic appliances manufacturer, Haier Group, its bid for Maytag, the US microwave oven and vacuum cleaner conglomerate, stumbled. The attempt of China National Offshore Oil Corporation (CNOOC) to acquire Unocal, a US oil company, with a 100 million dollar higher bid than its competitor's was intervened by the US government and finally blocked because of the serious national security concerns for the US. This gave rise to a feeling in China that the Chinese government should have a reciprocal legal system to evaluate proposed foreign takeovers.

Third, since the early 1980s, China has adopted 'Treatment of Foreign-Invested Enterprise (FIE),' which allows incentives in the aspects of tax, land use, loan conditions and others in order to attract foreign investment in China. There are increasing Chinese domestic companies taking advantage of this policy by registering an offshore company, using its shares to purchase stakes in domestic assets and then injecting the domestic assets into the offshore company for the purposes of being listed overseas afterwards. The New Regulation is targeted at closing the loophole and getting control of those assets.

Comparison of New Regulation and Old Regulation and
Highlights of New Rules Affecting Foreign Business in China

Based on a thorough comparison between the 2003 Old Regulation and 2006 New Regulation in the original language, the 61-provision New Regulation does not propose dramatic changes from the Old Regulation. It carries the 26 clauses in the Old Regulation with most provisions remaining unchanged and some with minor modifications. The 24 out of 35 new clauses in Chapter Four of the New Regulation are devoted to laying out detailed requirements, registration procedure and approval conditions for using share-swap for foreign investors' acquisitions in China, the incorporation of Special Purpose Vehicles (SPVs) by Chinese domestic companies or PRC residents and acquisitions by China domestic companies employing SPVs. The antitrust law provisions are copied from the Old Regulation. Most of the approval procedures and standards for the acquisitions of the Chinese domestic companies by the foreign investors remain unchanged. However, the New Regulation raises the threshold for EIE Treatment. Furthermore, the New Regulation confers enhanced authority on MOFCOM, together with other authorities, to enjoin or reverse the acquisitions of certain businesses. It also reconfirms and strengthens the authorities of approval by the MOFCOM and SAIC for acquisitions possibly threatening China national economic security or its national industries.

The noteworthy changes in the New Regulation affecting foreign investments in China are as follows:

New requirements for compliance with more Chinese laws and mandated approval from MOFOM for foreign acquisitions in China.

1.   New requirements introduced in the New Regulation call on foreign investors to satisfy the requirements of Chinese laws, and administrative regulations and rules concerning industrial, land and environmental protection policies (Article 4).
2.   The acquisition by the foreign companies shall not cause the loss of state-owned asset (Article 3).
3. The New Regulation also stipulates that foreign investors must observe the Chinese relevant laws and regulations as described in Articles 5 through 8, specifically:

a. Complying with relevant regulations governing state-owned assets when transfer of the state-owned assets and administration of state-owned equity of a listed company are involved in the foreign acquisition;

b. Obtaining approval of examination, comply with the procedures for amendment of registration or establishment registration with the registration administration authority;

c. Following the procedures with the securities regulatory authority of the State Council pursuant to the Measures Governing Strategic Investment Made by Foreign Investors in Listed companies when acquiring a China domestic listing company;

d. Paying taxes according to tax regulations of China and accept supervision of tax authorities; and

e. Following procedures of administration of foreign exchange (FOREX) for Forex approval, registration, filing and amendment in a timely manner in compliance with Chinese Forex laws and administrative regulations.

4. New Regulation reiterates that the foreign acquisition shall follow the 'Foreign Investment Industrial Guidance Catalogue' and the foreign investors are prohibited from acquiring PRC companies in the forbidden areas for foreign companies set in the Catalogue. (Article 4)

5. The most striking change in the New Regulation is the requirement for foreign companies to apply to MOFCOM for examination and approval in advance when:

a. The acquisition may result in transfer of the actual controlling rights of the PRC domestic companies owning any famous trademarks or traditional Chinese brands to the foreign company;

b. Such acquisition involves any major industry; or

c. The acquisition has or may have an impact on the state economy security. (Article 12).

This clause empowers MOFCOM together with other authorities to enjoin and reverse an acquisition that fails to do the above required report and may cause impact on the state economic security.

New qualification for the FIE Treatment.

New Regulation requires the ratio of foreign investment in FIE to exceed 25% of the registered capital of the FIE established by the foreign acquisition in order to qualify for enjoyment of the preferential treatment of FIE and administrative procedure for borrowing loans by FIEs. (Article 9)

Share Swaps ' Equity Payment-based Acquisition of Domestic Companies by Foreign Investors.

The 2003 Old Regulation first allowed share swaps in the acquisition by foreign investors in China but did not have any specific rules implementing it. The New Regulation promulgated detailed and restricted guidelines for foreign investors involved in the share swap acquisition to follow, including:

a. The foreign company involved in the transaction should be in compliance with all the requirements on its lawful establishment, the place of its registration must have a complete corporate legal system and free from the punishments from supervision agencies for the past 3 years;

b. The equity interests are not subject to any dispute of ownership or any lien or otherwise encumbrances;

c. The equity share for the foreign company has to be lawfully listed for public trade on the overseas securities exchange market excluding any sale-counter trade market; and

d. The trading price of the overseas company's equity shares has been stable for the recent one year. (Articles 27 through 38)

The above detailed provisions are aimed at giving more options for foreign companies in China for the payments of the acquisition, which can be considered as a positive step for China in introducing international M&A norms and encouraging more foreign investments.

For the first time, the New Regulation requires the domestic company or its shareholders to employ a registered agency in China as its acquisition consultant to conduct due diligence with regard to the truthfulness of the application documents and the overseas company's financial status required for the purpose of such acquisition. (Articles 30 and 31)

New Regulation and Its Impact on
Foreign Companies' Penetration in China Market

The New Regulation contains no defined terms on some important matters, such as definitions, factors or criteria used to determine:

a. 'Major industries', 'impact on the state economy security' and 'China's famous trademarks or traditional Chinese brands,' which are required to get approval from MOFCOM as mentioned in Article 12.

b. 'Large market share and other important factors that would materially affect market competition' as mentioned in Article 51; and

c. 'Improvement and the conditions for fair market competition,' 'advance technology and management talent,' which are qualified for exemption from examination under antitrust provision as mentioned in Article 54.

The above undefined terms give MOFCOM and other government authorities more discretion, power and leverage for deciding whether to approve or deny the foreign investor's acquisition, thus creating uncertainties and more risks for foreign investors to acquire the Chinese domestic companies. As China remains a country with a planned economy, this is nothing novel to foreign investors. The difference possibly resulting from this new rule may be that China becomes more serious and aggressive in carrying out the rule in restricting foreign investors' takeover of Chinese domestic companies for the purpose of market entry and Chinese domestic companies can use this rule to block foreign companies' acquisition of their competitors to avoid competition in the domestic market. It is important to note, though, that whenever there is uncertainty embedded in a government policy, creative strategies can be developed to obtain the required authorization.

With its accumulating and increasing knowledge in western countries' practice in promulgating laws and regulations, China may introduce more international practice in protecting its domestic industries while technically adhering to the market access schedule it has undertaken as a WTO member. As Vice Prime Minister Wu Yi addressed 160 multi-national business executives in Xiamen during China 10^th International Fair for Investment and Trade on Sept. 7, 2006, one day before the adopting of the New Regulation, China continues to promote foreign investment in the fields of agriculture, service industries and traditional manufacturing, research and development centers, new high-technology industries, advanced manufacturing, and the energy conservation and environment sectors. A strategy for focusing on these areas and using well-connected consulting, PR, legal and accounting firms with a good government affairs program in China is critical to help to smooth the process.