Merger and Acquisition Rules in China:
A Quick Roadmap

May Y. Hao
MayGlobe Law Firm
mhao@mayglobelaw.com
http://www.mayglobelaw.com

February 26, 2004

    Conventionally, the only vehicle for a foreign company to operate a business in China is by setting up a joint venture or a wholly owned subsidiary in China. Mergers and acquisitions are not available due to the lack of a clear legal framework in China.  The thorniest issues that have hindered the Chinese government from issuing merger and acquisition rules are issues concerning state owned entities.  

In the past few years, China has made tremendous efforts to restructure state owned entities and convert state owned entities into either partially or wholly privately owned companies. Along this process, the Chinese government has issued several rules and regulations regarding mergers and acquisitions by foreign companies in China (collectively, the “M&A Rules”).  The M&A Rules are composed primarily of the following rules and regulations: 

(i)    Notice regarding Transfer of State Shares and Legal Person Shares of a Listed Company to foreign Investors, dated November 1, 2002 (the “Notice on Transfer of State Shares”); 

(ii)    Provisional Rules on Administration of Investment in Domestic Securities by Qualified Foreign Institutional Investors, effective December 1, 2002 (the “QFII Rules”); 

(iii)   Tentative Provision on Using Foreign Investment to Restructure State Owned Entities, effective January 1, 2003 (“Provisions on Restructuring of State Owned Entities”); and 

(iv)   Provisional Rules on Mergers with and Acquisitions of Domestic Entities by Foreign Investors, effective April 12, 2003 (“Rules on M&A of Domestic Entities”). 

For people who are not familiar with the Chinese economic structure, the M&A Rules may appear a little confusing, because some of these rules are issued from the perspective of state-owned entities and some were issued from the perspective of foreign investors, and to a certain extent some of these rules are overlapping. The purpose of this article is to set out a roadmap to the Chinese M&A Rules.  

To understand the Chinese M&A Rules, one needs to understand the following two basic principles:

 1.       Investment Guidelines.  All foreign investment in China, whether direct foreign investment, such as a joint venture or wholly foreign owned entity, or an investment through a merger or acquisition transaction, is subject to industry policies embodied in the “Guidelines on Foreign Investment Directions” (the “Investment Guidelines”) issued jointly by the State Planning Committee[1], the State Economic and Foreign Trade Committee[2] and the Ministry of Foreign Trade and Commerce.[3]  The Investment Guidelines divide all industries into four categories: encouraged, permitted, restricted and prohibited. The Investment Guidelines provide a catalogue which contains detailed lists of different industrial sectors within each such category. If there is a restriction on foreign ownership interest in any industrial sector, the catalogue will specify the maximum percentage permitted for foreign ownership interest in such sector. The Investment Guidelines and its catalogue are generally user friendly.

 2.       Governmental Approval. By the same token, all foreign investment in China, whether direct investment or a merger or acquisition by a foreign company, is subject to governmental approvals. The general rules are that an investment of US$30 millions or above is subject to the approval by the Ministry of Commerce (or even by the State Council) and a foreign investment below that threshold will be approved by the local branch of the Ministry of Commerce. There are many exceptions to this rule; for example, a special economic zone may have authority to approve a larger project than a local government. In addition, for a foreign investment in certain industrial sectors, the approval may be required from a national or local agency in charge that industry.  All companies in China should be registered with the State Administration of Industry and Commerce or with its local office.  All companies in China are subject to the regulations on foreign exchange.

 With these two principles in mind, we may walk through the Chinese M&A Rules in two different scenarios:  publicly listed companies and non-publicly listed companies.

 Publicly Listed Companies

 Currently, two types of shares are traded on a Chinese stock market:  A-shares and B-shares. A-shares are shares denominated in the Chinese currency while B-shares are shares denominated in a foreign currency. Only a small portion of listed companies have been approved to issue B-shares and as a result, B-shares make up only a fraction of Chinese domestic market capitalization. As explained below, some A-shares are traded on a stock market, while the majority of A-Shares are not freely tradable.  Traded and un-traded A-shares are subject to different sets of provisions under the M&A Rules.

 Any foreign investor may freely purchase and sell B-shares, but only certain “qualified foreign institutional investors” (“QFII”), such as investment banks, insurance companies, etc., may purchase and sell traded A-shares on a stock market. Under the QFII Rules, traded A-shares to be acquired by any individual QFII may not exceed 10%, and traded A-shares to be acquired QFIIs as a whole may not exceed 20%, of the total issued and outstanding A-shares (including both traded and non-traded A-shares) of a listed company. [4]

  “Non-traded A-shares” are legally called “State Shares” and “Legal Person Shares”[5].  In China, most listed companies are originally transformed from a stated owned entity, and as of now almost all Chinese listed companies still have the majority of their outstanding A-shares held either by the state itself or by a state owned entity.  

 For a long time, foreign investors were not permitted to acquire State Shares or Legal Person Shares.  As part of the process to restructure state-owned entities, effective as of January 1, 2003, a foreign investor may either acquire State Shares or Legal Person Shares from the holders of such shares by itself or acquire such shares through its joint venture or wholly owned subsidiary in China. Under the Notice regarding Transfer of State Shares, a foreign investor may not transfer such non-traded A-shares to a third party within 12 months after it has paid the full share price.  In addition, any transfer by a foreign investor of non-traded shares is subject to the approval of the relevant governmental authority. It is not clear, under the M&A Rules whether or how the non-traded A-shares, after being acquired by one or more foreign investors, may become traded shares on a Chinese stock market.

 In China, very few private companies have been approved to be listed on a stock exchange; therefore, the M&A Rules do not address any issues relating to listed companies which are not transformed from a state-owned entity.

 Non-Listed Companies  

 Under the M&A Rules, a foreign investor may acquire an ownership interest in a non-listed Chinese company by either purchasing the equity interest from an owner or shareholder of such company or by contributing additional capital to such company.  A foreign company may also purchase assets of a domestic company through its existing or a newly formed joint venture or wholly owned subsidiary in China.  If a foreign investor decides to set up a new entity (a joint venture or a wholly owned subsidiary) in China to acquire assets from a non-listed Chinese company, such foreign investor may use the assets to be purchased as its capital contribution to its new entity in China.[6]

 For many years, non-performing debt owed by stated owned entities has been a major problem facing Chinese banks. China has taken several measures to resolve this problem. For example, the Chinese government has allowed banks to convert their non-performing loans into the equity of the debtors or to sell their non-performing loans to certain asset management companies or major foreign investment banks. Consistent with these measures, the M&A Rules specifically provide that a foreign investor may acquire rights from a Chinese bank and convert such creditor’s right into the equity of a debtor which is a stated-owned company. [7]

 A mandatory procedure for an asset purchase transaction involving a state owned company is the assets evaluation procedure. This procedure has existed for a long time and has applied to the formation of a Sino-foreign joint venture where the Chinese partner is a state-owned entity which contributes assets, instead of or in addition to cash to such joint venture.

 Status as Foreign Investment Entity

 A “Foreign Investment Entity” (“FIE”) is a legal status originally given to a wholly foreign owned company or a Sino-foreign joint venture with at least 25% of foreign interest. An FIE engaged in a “production” type of business (as opposed to trade or services) enjoys various tax and other benefits at both national and local levels.  At the national level, an FIE enjoys two years’ income tax exemption and three years’ 50% tax reduction. Similar or better tax benefits are also given to such FIEs at provincial and city levels.  One should be aware, however, that the tax and other benefits currently awarded to an FIE may fade away in the next few years due to China’s commitment under the WTO.

 Under M&A Rules, a listed company will not treated as an FIE even if a foreign investor holds 25% or more of traded and non-traded shares of such company.[8]  A non-listed company will be treated as an FIE as long as foreign interests constitute at least 25% of the total equity of the company.[9]  There is no explanation for such distinction.

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I hope that this article provides an efficient roadmap to the Chinese M&A Rules. One should always remember that the M&A Rules are operated in conjunction with other rules and regulations, such as rules and regulations issued by the Chinese Securities Regulatory Commission and anti-trust rules.  In addition, since the M&A Rules are sketchy in many aspects, one may find that many practical issues are virtually unaddressed in the M&A Rules.