Special Feature : The Feasibility Study Report: Some Frequently Encountered Issues and the Impact of WTO

RELEVANCE IN A MARKET ECONOMY

The term market economy is not used here in the sense in which it might be understood elsewhere. It is used as a convenient reference to the PRC's previously rigid centrally planned economy but which now admits of certain market characteristics, including those features required to be introduced or removed as a result of the PRC's imminent accession to the WTO.

Here, the question which seems to be increasingly posed is, given the increasing market nature of the economy, is it necessary to amend or update the feasibility study report upon a business expansion or prior to an acquisition of a business? A reason for not amending the feasibility study report is that because increasing types and amounts of resources, utilities and supplies are available and can be purchased in the open market at market terms and prices, this diminishes the role and importance of State allocation of these items which, in turn, lessens the importance of the feasibility study report.

This view, if anything, would seem to be reinforced by the recent amendments to the PRC Sino-foreign Cooperative Joint Venture Law (中华人民共和国中外合作经营企业法)(the CJV Law) and the PRC Wholly Foreign-owned Enterprise Law (中华人民共和国外资企业法)(the WFOE Law) adopted by the Standing Committee of the National People's Congress in anticipation of the PRC's accession to the WTO. These amendments became effective on October 31 2000. The amendments are part of the legislative programme to establish national treatment for foreign investment enterprises and many of the items affected (discussed directly below) are those that fall squarely within the domain of the feasibility study report and the purview of the relevant authorities.

Foreign Exchange Balancing

The previous requirements that cooperative joint ventures (CJVs) and wholly foreign-owned enterprises (WFOEs) had to balance their foreign exchange income and expenditure have been removed. The department-in-charge of a WFOE is no longer in theory responsible to remedy an imbalance in foreign exchange income and expenditure caused by the department-in-charge permitting the WFOE to sell its products on the PRC domestic market.

Purchase of raw materials

Previously, WFOEs were required to give preference to domestic suppliers when purchasing raw materials. This requirement was, of course, a corollary of the requirement that WFOEs balance their foreign exchange income and expenditure. This requirement has now been removed thereby allowing WFOEs a freer hand to purchase from both domestic and international suppliers. This removal is also consistent with the current account convertibility of the Renminbi.

The changes described above mark a significant change in the centrally planned regime of which the feasibility study report is an element.

Types of WFOEs

Previously, in short form China parlance, WFOEs had to be either technologically advanced enterprises or export-oriented. The WFOE Law has now been amended so that a newly formed WFOE need not necessarily satisfy either of these two criteria. It is sufficient if the WFOE benefits the development of the PRC national economy although the establishment of technologically advanced enterprises or export-oriented enterprises is still particularly encouraged. Although it is not clear at this stage whether this change in the law will herald the establishment of a wider range of WFOEs (there are two reasons for this: first, it may be a gradual process for approval authorities to implement the change in the law in practice; and, second, quite perversely, it can be argued that the threshold for what is technologically advanced had been pitched so low previously that it cannot effectively be lowered as a result of the change in law), the removal of the export requirement does mark a departure from the central planning philosophy.

Production plans

In a further downplaying of centrally planned control, the previous requirement that a WFOE had to prepare and submit production plans to its department-in-charge has been removed.
Similar amendments are also expected to be made to the laws relating to equity joint ventures in the first half of 2001.

DEALING WITH THE FEASIBILITY STUDY REPORT

Action may be taken by the relevant planning commission against a business which is not in compliance with its feasibility study report. For the potential purchaser of a business, the primary concern is what action a planning commission might take against it or the business that it has acquired. Although the feasibility study report is an historic document in the sense that it is prepared at the feasibility stage of the project, it can also be regarded as an understanding or compact between the investors and the relevant planning commission and any action inconsistent with such an understanding as recorded in the feasibility study report could lead to problems between the investors and the relevant planning commission.

For example if, in the process of approving the feasibility study report, the relevant planning commission requires that the investors incorporate certain features or equipment in the project51s design or processes (for example, that equipment to be used in the project meets certain environmental standards) and these features and equipment are not adopted, then the planning commission may take action against the project. In taking such action, it may enlist the assistance, for example, of the local environmental protection agency and the State Administration of Industry and Commerce.

A sensible potential purchaser should therefore review the contents of the target51s feasibility study report carefully prior to any acquisition or reorganization to check that there are no:

a) inconsistencies between the feasibility study report and the manner in which the purchaser believes the business has been, and can continue to be, operated;

b) fundamental issues raised in the feasibility study report which have been ignored or neglected; and

c) assumptions in the feasibility study report which are or have turned out to be flawed or erroneous.

It is essential for the purchaser to ascertain such inconsistencies with, or deviations from, the feasibility study report, to assess the potential risks and to determine how such risks can be addressed. Having said this, the commonly relaxed attitude towards feasibility study reports can be demonstrated by the observation that many professionally commissioned due diligence reports do not even mention the feasibility study report. From the vendor51s point of view, it is necessary to anticipate that such issues will be raised and to consider possible solutions or assurances that can be advanced during negotiations with the purchaser. Examples of such issues commonly encountered include the following:

No feasibility study report

It is not unusual to encounter projects in respect of which no feasibility study report has been approved or even prepared. In such cases, the local approval authority may have stated that a feasibility study report is not legally required and the original investors may have decided to rely on this statement. In other cases, possibly with the tacit cooperation of the local approval authority, it has been dispensed with. It was probably felt that the approval of a feasibility study report would have meant a delay and, as the project does not require an allocation of resources from the plan administered by the planning commission, the feasibility study report could be dispensed with because no reliance on the relevant planning commission to allocate such resources is necessary. As discussed earlier, this sort of view is gaining a wider currency as China moves from a centrally planned economy to a market economy (albeit one with socialist characteristics), resources become more readily available on the open market and since foreign exchange became convertible on the current account.

For a potential purchaser, the acceptability of such a risk depends on a mosaic of factors. These include, for example:

a) the location of the project;

b) the attitude of, and the support and assurances given by, the project51s original examination and approved authority;

c) the business activity of the project; and

d) the availability of resources on the open market.

The risk may be considered to be at the lower end of the scale in the case of a light industry assembly facility with a small total amount of investment located in a technology zone. Such a facility would not require heavy raw materials that are centrally allocated and there is a reasonable level of confidence that basic utilities can be assured by the zone51s authorities. In contrast, the risk would clearly be high in the case of a large manufacturing plant whose input and output may require State coordination and assistance. The difficulty really lies with the larger projects in the former category where assessing the risk and determining what remedial action may be needed may require a fine judgment.

Insufficiency of feasibility study report

More common, however, are cases where there is a feasibility study report, but a potential purchaser may find that the original scope of the feasibility study report has been exceeded by the operations of the project. This scenario presents the classic dilemma of whether the feasibility study report should be updated or simply left alone as an historic document (see box entitled "Amending a Feasibility Study Report"). Where the local planning commission has begun to exert its authority, for example by refusing to coordinate the supply of power or other utilities because the feasibility study report does not contemplate the need for such quantities of utilities, it is clear that remedial action will be required.

Where no action by the authorities has been taken, the course of action is less clear. The risk of possible action by the authorities in the future needs to be balanced by the risks and delays in submitting a revised or supplementary feasibility study report. The considerations in the section above would be relevant. Where it is felt that the project can continue to operate without reliance on the local planning commission, the risk of intervention by the local planning commission is small and there is an open market supply of the utilities or materials required, the preferred course of action may be to retain the status quo.

Standard form feasibility study report

Here, a feasibility study report has been prepared but, in order to smooth the approval process, it is in a standard form prepared by the original examination and approval authority. In such cases, the approval authority is usually that of a technology zone or of a small township that is eager to attract investment. Whilst there is nothing objectionable in this approach, it is important for a potential purchaser to check that the standard form provisions of the feasibility study report do not contain any provisions which contradict how the purchaser believes the project is being or can be run. In particular, many of these standard form provisions will express certain idealised outcomes or exhortatory mandates: even if these have been largely ignored to date, it is important to make sure that these do not come to bind the business or the purchaser. It goes without saying that the feasibility study report is not likely to have accommodated the special features of the project and the purchaser must therefore consider whether there are any shortcomings in this respect.

Delay between approval of the feasibility study report and approval of the project

Where the establishment of the project has been long in gestation, there may be a considerable interval, sometimes a few years, between the preparation or approval of the feasibility study report and the approval proper of the project. In such a case, there may be significant discrepancies between the feasibility study report and one or more of the other important establishment documents such as the joint venture contract. Often these discrepancies relate to fundamental issues such as the type or generation of technology to be used by the project, the importation of raw materials or components required by the project or even the total amount of investment or business purpose of the project. The reasons for such variances may have been caused, among other reasons, by changes in technology, an internal reorganization of one of the foreign investors, a change in the market for which the products of the project are intended, or a change in the policies of the PRC government (the latter could either have been a restrictive change or a relaxation of restrictions leading to more competitors in the PRC than originally foreseen). In addition, any valuations included in the approved feasibility study report which formed a party51s contribution-in-kind to registered capital should have been refreshed after the expiry of one year.

For the purchaser, consideration needs to be given to whether a new or supplementary feasibility study report should be prepared or whether, at the least, a submission should be made to the relevant planning commission asking it to approve the variances. Such a step should be taken where the discrepancy is either fundamental in nature or involves a matter in relation to which reliance on the relevant planning commission is necessary (for example the supply of a raw material which is centrally allocated).

Whether a new or supplementary feasibility study report is required for a new or enlarged business activity

A new or supplementary feasibility study report may be required where, upon the acquisition of the business, the purchaser intends to engage in a new or enlarged business activity. In such a case, the existing business scope, registered capital and total amount of investment, among other things, will probably need to be amended through amendments to the joint venture contract, the articles of association and business license. These amendments will need to be approved by the project51s original examination and approval authority.

As to whether a new or supplementary feasibility study report should be prepared and submitted for approval, the following criteria may be considered:

Change in the fundamental nature of the project. Where the fundamental nature of the project as it is originally defined in the feasibility study report is being changed, this would suggest that the feasibility study report should be amended. Whether or not there is a change in the fundamental nature of the project does not necessarily depend on any single amendment, say, for example, an increase in the total amount of investment. In such a case, the more relevant question may be to ask for what purpose the extra financing is required. Minor amendments may not necessarily require corresponding amendments to the feasibility study report.

Statutory requirement. There exist certain statutory provisions that require a feasibility study report to be produced in order for a particular action to be taken or thing to be done. In this context, where a capital increase to expand production capacity is proposed which may affect comprehensive national balancing and/or involves projects falling within the Restricted B category, a feasibility study report regarding the capital increase is required to be prepared and submitted to the State Development Planning Commission for approval.

Original approval limit exceeded. If there is an increase in the project's total amount of investment and the new total amount of investment exceeds the approval limit of the original examination and approval authority, then the amendments will need to be approved at a higher level. In such a case, a new feasibility study report may be required.

Attitude of original examination and approval authority. The stance taken by the original examination and approval authority when its approval is sought for amendments will be particularly telling in assessing the necessity or desirability of approaching the local planning commission to amend the feasibility study report. One approach may be to make a written submission to the relevant planning commission to seek its confirmation on the changes. This may secure effectively the same assurances within a shorter time and without the need to prepare a full-blown feasibility study report.

Feasibility study reports of related projects

There may be a situation where the project being acquired was originally established as one in a series of projects. This may have been done for legitimate commercial or technical reasons as in the case of a series of plants set up to produce related upstream and downstream products, or each housing a separate production line, as well as perhaps to keep the total amount of investment of each project below the limit which a local approval authority can approve. Conversely, the decision to split the projects may have been solely influenced by the approval limit issue with there being no other business or technical reason to divide the projects. In either case, the potential purchaser should request to inspect the feasibility study reports (and all other relevant documents) of each related project as there will inevitably be issues contained in these documents that will impact the target project.

Feasibility study report prepared only by the PRC investor

The feasibility study report is supposed to be prepared jointly by the PRC and the foreign investors. In some cases, the Chinese investor may have offered to prepare the feasibility study report by itself or may simply have done it of its own initiative. In any such case, the potential purchaser needs to review thoroughly the feasibility study report as the risk is that the feasibility study report may contain statements skewed in favour of the PRC investor (for example that the foreign investor is to provide certain technology) or which may not be consistent with the foreign investor51s intentions (for example it will second a certain number of technical personnel to the project). A potential purchaser may also discover that the feasibility study report was prepared by a design unit or consultancy unit possibly associated with the PRC investor. There is nothing necessarily objectionable in this but the document should be reviewed carefully in the normal course and the purchaser should be sensitive to the fact that the entrusted design unit may not have been familiar with the project when it prepared the feasibility study report.

Relationship between the feasibility study report and the project proposal

Prior to the preparation of the feasibility study report, the PRC investor should have prepared a project proposal to its department-in-charge for the purpose of obtaining approval to establish the project. Although the project proposal is a document that is internal to the Chinese investor, it is statutorily required and, in some cases, the original foreign investor would have had an opportunity to review this document. For the original investor, points to look out for include seeing how the PRC investor tries to sell the project to its department-in-charge and ensuring that the PRC investor has not over-promised or oversold the project. In addition, an opportunity to review the related correspondence between the PRC investor and its department-in-charge would be welcome. For a potential purchaser of the business, it is necessary to determine whether there are any discrepancies between the project proposal and the approved feasibility study report. If the vendor (if it is the original foreign investor) is unable to produce a copy of the project proposal, it will still be useful to ascertain whether the vendor had the opportunity to review the project proposal and to raise fundamental issues (it is rare for the foreign investor to influence the actual drafting of the project proposal itself as it is a document internal to the PRC investor). In certain technology or development zones, it is now not unusual to come across a single document that combines the project proposal and the feasibility study report. In such cases, it is typically the same approval authority in the zone that approves both the project proposal and the feasibility study report. For a potential purchaser, enquiries should be made to determine that the foreign investor had a role in preparing the document.

CONCLUSION

Traditionally, feasibility study reports were seen as documents associated with the start of a project's life. As mergers, acquisitions and reorganizations of foreign investment enterprises increased, investors have had to look at feasibility study reports in new circumstances. This article has discussed some common scenarios in those circumstances and has suggested some possible approaches to the issues raised. The feasibility of using these approaches needs to be assessed having regard to the facts of each case. It is quite clear that, in certain cases, for example large projects, very little flexibility may be allowed. However, in others, a potential purchaser may take the view that it is prepared to proceed without undertaking a full revamp of the feasibility study report on the basis that there is a sufficient disconnect between the actual operations of the target project and the original role of the feasibility study report.