Regulating M&A activity

The recently implemented provisional rules on mergers and acquisitions involving Chinese enterprises provide for potentially sweeping antitrust requirements that could have major implications for foreign investors.

The Provisional Rules on Mergers with and Acquisitions of Domestic Enterprises by Foreign Investors offer a legal basis for the acquisition by foreign investors of assets from and equity interests in Chinese domestic enterprises. They also provide for potentially sweeping antitrust review requirements that apply to offshore mergers as well as to acquisitions of domestic companies by foreign investors. The antitrust provisions in the new rules, which went into effect on April 12, will need to be considered carefully by those multinationals with a substantial market presence in China.

The provisional rules apply to both mergers with and acquisitions of Chinese domestic companies (excluding FIEs) by foreign investors, covering the following methods:

acquiring the equity interests of domestic companies;

subscribing to increased capital of domestic companies;

purchasing assets of domestic enterprises to invest in a foreign investment enterprise (FIE) established to use the assets; or

establishing an FIE to purchase assets of domestic enterprises

Unlike for equity acquisitions, the provisional rules for asset acquisitions apply to all domestic 'enterprises' rather than only domestic 'companies'. This is understood to include FIEs.

Before the provisional rules were issued, there was no adequate legal basis for foreign investors to engage in the type of M&A activity covered under the provisional rules, although in practice local authorities had approved a number of acquisitions of equity interests in domestic enterprises by foreign investors on a case-by-case basis.

Each of the M&A methods addressed in the provisional rules results in the establishment of FIEs. In the case of an assets purchase, foreign investors will not be allowed to own domestic assets from offshore; rather, domestic assets purchased must be used to set up an FIE. Thus, the provisional rules are designed to attract long-term foreign investors to restructure domestic enterprises. Foreign investors will be allowed to acquire up to 25 per cent of a domestic enterprise. Although such enterprises will enjoy FIE status, they will not be eligible for preferential tax treatment.

Foreign investors must use a Chinese valuation institution to assess the value of the acquisition target, based on internationally accepted valuation methods. If state-owned assets are involved, different valuation methods will be used in accordance with existing regulations relating to the administration of state-owned assets. In any case, the transfer of equity interests or sale of assets to foreign investors shall not be permitted at a price obviously below the value determined through appraisal.

Responsibility for liabilities

Another important consideration is which party bears responsibility for the domestic enterprise's liabilities. Under the provisional rules, if a foreign investor acquires equity in a domestic enterprise, the resultant FIE assumes the liabilities of the original domestic enterprise. But if a foreign investor purchases assets, the domestic enterprise that sold the assets continues to bear its original liabilities. A notification to all creditors and a public announcement in a newspaper at or above provincial level with national circulation must be made before a domestic enterprise can sell assets, and creditors may require the domestic enterprise to provide security. Presumably if the enterprise cannot provide security satisfactory to the creditors, the creditors may block the assets transfer.

Subject to the approval of foreign exchange authorities, foreign investors will be allowed to use stock or yuan as consideration for the acquisition in addition to convertible currency. In general, payment must be made within three months from the date on which the business licence of the newly established FIE is issued. If required, and with approval, this may be extended to at least 60 per cent payment within six months and the balance within a year. The Ministry of Foreign Trade and Economic Co-operation (Moftec) or its local branch at the provincial level is the approval authority, and a decision on approval is to be made within 30 days from receipt of all required documents unless the proposed transaction has antitrust implications requiring a hearing. In such a case, Moftec and SAIC have 90 days to convene a hearing even before an approval decision is rendered.

In applying for approval in conjunction with any of the types of M&A activity permitted by the provisional rules, the foreign investor must include a plan to resettle the employees of the domestic enterprise that is either disposing of its assets or being acquired. This requirement is not a feature of traditional regulations governing foreign investment, and may add to the expense of the transaction as well as opening up another area for negotiation.

Finally, although under China's Contract Law a foreign party may choose a foreign law to govern contracts to which it is a party (apart from Sino-foreign joint venture contracts and other limited exceptions), the provisional regulations provide that agreements for (1) the acquisition of an equity interest in, or (2) subscription for an increase in the registered capital of, or (3) the acquisition of assets of, a domestic enterprise must be governed by Chinese law.

Antitrust measures

Article 3 of the provisional rules includes a stipulation that mergers and acquisitions may not 'result in excessive concentration and exclusion or restriction of competition and may not disturb the social or economic order or harm public interests'. Subsequent articles set out a series of thresholds under which a proposed transaction will trigger reporting requirements and possible antitrust scrutiny. The provisional rules establish two separate sets of triggers for antitrust review, one for onshore and one for offshore merger and acquisition activities

Investors involved in a merger or acquisition of a domestic enterprise must report to Moftec and SAIC if any of certain triggers apply to the proposed transaction. Article 24 suggests that these antitrust review triggers, unlike the other provisions of the provisional regulations, would apply to equity acquisitions by foreign investors of existing FIEs.

The notification triggers are:

business turnover in the China market in the current year of a party in the merger or acquisition exceeds Yn1.5bn;

the aggregate number of mergers and acquisitions of domestic enterprises in the relevant industry in China within one year exceeds 10;

the China market share of a party in the merger or acquisition has reached 20 per cent; or the merger or acquisition will result in the China market share of a party in the merger or acquisition reaching 25 per cent.

Proposed mergers or acquisitions that do not trigger a review under any of these tests may still be subject to review if a competing domestic enterprise, relevant authority or industrial association requests a review, and Moftec or SAIC believes that the merger or acquisition involves 'substantial market share or any other major factor that may substantially influence market competition, the national economy and livelihood or national economic security'.

While the market share provisions appear to set workable standards (subject to the inherent complexities of market definition), it is unclear how the business turnover threshold will be applied in practice. As a separate threshold applied in conjunction with market share triggers, this standard may be used to focus administrative resources on relatively large markets. However, if each of the four standards is deemed to independently trigger antitrust review, as appears likely from the language of the drafters, then the implication is that Moftec and SAIC intend to review any merger involving players with large annual turnovers regardless of the significance of the market share or anti-competitive effects involved.

The provisional rules explicitly assert jurisdiction over offshore mergers and specify a distinct set of review triggers for such mergers. A proposed offshore merger must be submitted to Moftec and SAIC for approval either before the merger is announced or when such a plan is submitted to the competent authority of the local country. Any of the following triggers may require Chinese review and approval:

the assets within China owned by a party involved in the merger or acquisition exceed Yn3bn;

the business turnover in China in the current year of a party in the merger or acquisition and its affiliates exceeds Yn1.5bn;

the China market share of a party to the merger or acquisition and its affiliates has reached 20 per cent;

the merger or acquisition will result in the China market share of a party to the merger or acquisition reaching 25 per cent; or as a result of the offshore merger or acquisition, the party involved will directly or indirectly hold equity in more than 15 foreign investment enterprises in China.

The assets test, which is not listed as a trigger for onshore mergers, could potentially hamper the worldwide M&A activities of major Chinese investors if enforced as an independent trigger as contemplated by the language of the provisional rules. This test could subject an offshore worldwide merger of two large corporations to review and approval in the event that one of the corporations had a substantial capital-intensive investment in China. If applied independently of the market share triggers, this test would seem to overreach the purpose of antitrust regulation given that there is no explicit linkage between such a standard and China's industry concentration.

Unanswered questions

Perhaps most significantly, the provisional rules represent the first explicit attempt by Chinese regulators to exercise antitrust jurisdiction over offshore corporate mergers. This development has major implications for foreign multinationals that are investing or selling into China. Unfortunately, the Chinese legal system's lack of experience with this highly technical area is evident in the lack of clarity and detail in the provisional rules' antitrust provisions. Clarification and interpretative guidance are urgently needed to help foreign investors and multinationals assess their compliance obligations in this area. For the time being, companies contemplating transactions where the parties have activities in China would be well advised to carefully consider the potential applicability of the provisional rules.

This article was written by Thomas E Jones, Partner, Freshfields Bruckhaus Deringer, Hong Kong. He will head up the firm's recently launched antitrust, competition and trade practice in China.