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 cooperatives 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, foreign investors will be limited by the QFII guidelines set up by 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 'state-owned' or 'legal person' shares (see note below).
Until recently, foreign investors were expressly prohibited from purchasing non-listed 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 investment. In the case of investments in listed mid-cap 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 B-share 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 mid-cap 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.