China's heavily protected banking sector is being opened up gradually following WTO membership, with foreign participation now allowed in a number of limited forms.
The acquisition of strategic stakes in China's national, regional and city commercial banks remains a topic of keen interest to foreign investors. This is despite the fact that foreign investment approvals in this area seem to have been temporarily placed on hold following China's restructuring of its central ministries and administrative bureaus in April this year. This restructuring included the formation of the China Banking Regulatory Commission (CBRC) to take over the regulation of banks and other financial institutions from the central bank, the People's Bank of China (PBOC), which will remain in charge of monetary policy.
This article deals with current regulatory issues associated with acquiring strategic stakes in China's national and regional joint stock banks and city commercial banks (mid-cap banks). This category excludes the four major state-owned commercial banks and national 'policy banks' on the one hand, and the smaller urban and rural credit co-operatives on the other.
The banking sector in China is, at least for the time being, heavily protected. Foreign participation is permitted in a number of limited forms, although each form carries significant restrictions both in terms of geographic operation and scope of business activities.
Under China's WTO commitments, the restrictions on foreign participation in the banking sector are scheduled to be relaxed in incremental stages up until December 11, 2006. However, even after 2006, the road to building an effective foreign bank presence in China will continue
to be very difficult. The rationale for acquiring trategic
interests in Chinese banks thus include:
Acquisition of domestic branch networks
The developmentof foreign branch networks from scratch is costly and subject to significant regulatory hurdles. A strategic investment would allow a foreign investor to position itself for a future acquisition of a controlling interest in a midcap bank, thus enabling it to indirectly acquire an existing branch network.
Access to restricted business activities
Mid-cap banksare not subject to the same constraints on business activities as foreign investment vehicles. A strategic acquisition prior to 2006 would allow a foreign investor to engage indirectly in banking businesses that are currently open only to domestic banks.
Strategic investment opportunity
Mid-cap banks are generally perceived to have lower non-performing loan ratios and healthier balance sheets than the four major state-owned banks. While this is not true for all mid-cap banks, many foreign investors believe that the introduction of advanced management and corporate governance practices to the more promising mid-cap banks will significantly enhance their return on investment.
Developing relationships with mid-cap banks could lead to ï¿½reverse business flowsï¿½ where domestic clients of mid-cap banks utilise the services
of the foreign investor for investments outside China. There may also be follow-on co-investment opportunities in
China with the major shareholders of midcap banks.
Making the acquisition
The majority of mid-cap banks are incorporated as joint stock limited companies under China's Company Law. Some of these banks, such as Minsheng Bank, have relatively
diverse shareholdings, including both state and non-state ownership. Most, however, have fairly concentrated and predominantly state shareholdings.
Foreign strategic investments in mid-cap banks to date have taken the form of direct purchases of new shares, or secondary purchases of shares from existing shareholders.
Quasi-equity investments in the form of convertible debt have begun to appear in other sectors but further complicate the approval process. Preferred equity is not yet provided for under China's company laws.
China Banking Regulatory Commission
Given the recent number of highly publicised strategic acquisitions, readers may be surprised to know that foreign investment in Chinese banks is actually prohibited under an official notice issued by the PBOC in
1994. This notice remains in effect today and there is still no formal regulatory basis for investments in mid-cap banks. However, despite this prohibition, the PBOC has, in the past, approved strategic acquisitions on a
New bank investment rules that are currently before the State Council in draft form are widely expected to lift the blanket prohibition on foreign investment in mid-cap
banks and provide qualitative foreign investment criteria. While little is known about the proposed bank investment rules, they should establish the CBRC as the approval authority with broad discretionary powers for all
foreign investment applications. In the past, because such authority had not been delegated to the PBOC, each transaction had to be approved directly by the State Council, a lengthy and highly political process. The
devolution of authority to the CBRC should lead to a more rules-based and predictable approval procedure.
Ministry of Finance
The purchase of shares in a mid-cap bank from the state or
from a state-owned enterprise will trigger mandatory state asset valuation requirements. Under rules designed to prevent the disposal of state assets at less than fair
value, the acquisition of shares held by the state or a
state-owned enterprise must be appraised by a valuer
authorised to conduct stateowned asset appraisals in
China. The results of the appraisal must then be verified
and filed with the Ministry of Finance (MOF), or its provincial counterpart, and the transaction executed at or near the appraised value of the shares.
If the shares are held by the state or a state-owned enterprise in a listed midcap bank, then the transaction
itself, not merely the results of the appraisal, must be approved on its merits by the MOF.
China Securities Regulatory Commission
The purchase of shares in listed mid-cap banks requires special consideration. Foreign investors are currently prohibited from acquiring shares on China's A-share markets unless the foreign investor has obtained
Qualified Foreign Institutional Investor (QFII) status from the China Securities Regulatory Commission (CSRC). However,QFII status is only available to those foreign
institutions engaged in fund and asset management activities, not for those seeking to make private equity purchases. Therefore, acquisitions of listed mid-cap banks generally need to take the form of privately negotiated purchases from existing shareholders that hold non-listed ï¿½state-ownedï¿½ or ï¿½legal personï¿½ shares (see note below).
Until recently, foreign investors were expressly prohibited from purchasing nonlisted state-owned or legal person shares in a listed mid-cap bank. The ban was effectively lifted pursuant to a notice issued by the CSRC, the MOF and the former State Economic and Trade Commission on November 4, 2002. This notice is of major significance as it now provides a legal basis for the acquisition of these types of shares in A-share listed companies.
The notice requires that the parties register any change in ownership of a listed company with the appropriate securities registration and clearing institution. In Shanghai, this institution is the local branch of the China Securities Depository and Clearing Corporation (or Shanghai CSDCC). Approval by the marketing department of the CSRC is required before the Shanghai CSDCC will register the share purchase.
Key structuring considerations
Making a strategic acquisition in a mid-cap bank requires special consideration of the unique industry risks facing China's banking sector. Competition among the mid-cap banks and with the national state-owned banks is fierce and, with eventual market liberalisation post-2006, many mid-cap banks are not expected to survive.
Senior management of the mid-cap banks will thus face important strategic business decisions over the coming years. It is therefore crucial that foreign investors negotiate up-front effective means of participating in the decision-making processes of the mid-cap banks. This may require negotiating with the bank's major shareholders for minority shareholder protection rights, such as board representation, management positions, veto rights and access to information.
Foreign investors must also pay special attention to rules governing the disposal of their shares. There is not, at present, a liquid market for the disposal of a foreign investor's interest in mid-cap banks. Any disposal of shares to another foreign investor will likely entail a similarly arduous regulatory process associated with making a new foreign invest- ment. In the case of investments in listed midcap banks, foreign investors cannot (at least for the time being) list their shares for sale on the A-share market during any subsequent public offering by the bank. While it is possible to seek a listing of shares on China's Bshare market, this is not an attractive option given the anaemic state of the market.
Finally, valuation and pricing will pose major challenges for the strategic investor. Significant time and effort must be expended on assessing the health of the mid-cap bank's loan portfolio, as lending practices have often suffered from undue influence by local governments and powerful shareholders. Pricing will also be difficult. In the case of listed midcap banks, their listed A shares trade at valuations far greater than what strategic investors have been prepared to pay for their purchase of non-listed illiquid state-owned or legal person shares.
Note: The non-listed shares of Chinese companies are classified in two categories under Chinese regulations: 'state-owned shares' and 'legal person shares'. Unfortunately, the distinction is artificial and misleading, as both types of shares belong to the identical class. The difference in terminology is used to describe the status of the owner. 'State-owned shares' are those shares owned either directly or indirectly by the state. 'Legal person shares' are those shares owned by any entity that is recognised as a legal person under Chinese law.
Simon Cheong is a senior associate with the international law firm Freshfields Bruckhaus Deringer based in Beijing. He was recently seconded to the World Bank Group's International Finance Corporation where he advised on strategic investments in China's banking and insurance sectors. The author acknowledges the contribution of paralegals Leland Fong and Wu Zheng Rong in researching this article.