Foreign Capital and SOEs: China's Forays into State Enterprise Reform

While SOEs still constitute the main pillar of China's economy, they suffer from inefficient management, high levels of debt, a surplus of workers and heavy social security burdens. In 1997, the Chinese authorities decided that major efforts should be taken to relieve the problems of large and medium-sized SOEs within three years. To assist this effort, the government has formulated a series of regulations in respect of foreign investment, finance, securities, customs and foreign trade. At the same time, other ongoing reforms are designed to modernize corporate practices and strengthen corporate governance.

The Tentative Procedures, together with two other regulations issued earlier in November 2002 that allow foreign investors to invest in China's securities markets (including acquiring state shares and legal person shares of listed companies),¹ are viewed as the base from which a new policy framework for using foreign capital to reform SOEs will be developed in China.

Scope of Application

The Tentative Procedures are aimed at regulating the restructuring of SOEs and the subsequent establishment of FIEs.² However, the new regulations' scope of application specifically excludes taking any participation in financial enterprises and listed companies.³

Five forms of restructuring are governed by the Tentative Procedures:

(i) foreign investors can restructure a state-owned enterprise into a FIE by acquiring all or part of the state interest (国有产权)in the enterprise;

(ii) foreign investors can restructure a company with state shareholdings (含国有股权的公司制企业)into a FIE by acquiring all or part of the state shareholdings(国有股权);

(iii) domestic creditors of a state-owned enterprise can transfer the debt owed by the enterprise to foreign investors and the enterprise is restructured into a FIE;

(iv) foreign investors can acquire all or the major assets of a state-owned enterprise or of a company with state shareholdings and, with such assets, establish a FIE either on its own or jointly with the seller of such assets; and

(v) a state-owned enterprise or company with state shareholdings can take on foreign investors as shareholders by way of a capital increase or new share issues and become a FIE.

Types of Foreign Investors

Under the Tentative Procedures, "foreign investors" may include foreign companies, enterprises, economic organizations and individuals. As is usually the case, the Tentative Procedures will apply equally, by way of reference, to investors from Hong Kong, Macau and Taiwan as well as FIEs already operating in China and involved in the reform of SOEs.⁴

There are no minimum asset value requirements for the foreign investors. However, foreign investors are generally required to contribute capital, "advanced technology" and "business management expertise" to the SOEs, they should be already engaged in the same or similar industries to that of the target SOE and they should have medium- or long-term investment plans. Other broad qualification criteria include sound commercial reputation, strong financial standing and economic strength.⁵

Market Share Consideration

Interestingly, for approval purposes, the Tentative Procedures also require information as to the share of the Chinese market that is already under the proposed foreign investor's actual control in the same industry of the SOE.⁶ Although no clear guidelines are given in the new regulations in this regard, this requirement is reminiscent of a stipulation included in MOFTEC's pending Administrative Measures on Acquisition of Equity Interests or Acquisitions of Assets in Domestic Enterprises by Foreign Investors (MOFTEC's pending Administrative Measures).

Restructuring Plan

Foreign investors are required to produce a comprehensive restructuring plan for the target SOE before the Chinese party initiates government approval procedures.⁷ The restructuring plan should aim at improving corporate governance structure and promoting continuous development of the enterprise. The contents of the restructuring plan should include development of new products, technology renovation and related investment plans as well as methods of strengthening corporate business management. Under the Tentative Procedures, the restructuring plan is one of the main documents to be submitted to the Chinese authorities for approval.⁸

Approval Authority

Approval issues remain among the first and most difficult questions faced by foreign investors. The Tentative Procedures provide that any SOE proposing to undergo a restructuring involving foreign investors must receive the necessary approvals from the government. If the new FIE resulting from a restructuring under the Tentative Procedures would have total assets of more than US$30 million, approval authority is at the central level.⁹

However, the Tentative Procedures do not clearly identify which government department will take overall charge of the process of examining and approving a SOE restructuring. They simply refer to "economic and trade departments of the same level" to which an approval request shall be submitted and require that the acquisition agreement shall be approved by "finance departments".¹⁰

The Tentative Procedures are not clear as to which departments shall have the final say in foreign investment issues, and do not make clear whether subsequent approval of one department is conditional on the earlier approval of another. Since several government departments may have jurisdiction over various aspects of an acquisition and restructuring transaction and foreign investors may be confused as to which department should be approached first to commence the approval process. Also, it is not completely clear what role(s) MOFTEC would play vis a vis other relevant departments.

Approval Procedures

The Tentative Procedures provide a cumbersome and multi-stage approval procedure for restructuring a SOE into a FIE.¹¹

First, approval by the "economic and trade department of the same level" is required for the restructuring application and related documentation. This includes the feasibility study, basic information about the parties, audited accounts of the foreign investor for the prior three years, reorganization plans, plans for employee arrangements and for credit and debt settlements, future business scope and shareholding structure of the new FIE, among other materials.

Second, approval by the finance department of the "acquisition agreement" itself is required.

Finally, on the strength of the above two approvals, approval is required for the establishment of the FIE followed by its business registration.

The Tentative Procedures are not clear how the various procedures work with each other, e.g. how MOFTEC's existing procedures for the approval of the establishment of FIEs will fit into the procedures described in the Tentative Procedures. For example, as the restructuring application will be approved by the economic and trade department and the acquisition agreement by the finance department, it is uncertain whether MOFTEC should also examine and approve the restructuring feasibility study and the acquisition agreement or whether MOFTEC's procedures for FIE establishment will become pro forma procedures after the relevant approvals have been granted by the other two departments.

Employees

Foreign investors must consider the various employee issues involved in an acquisition of a SOE. This is a complicated area that may impact significantly on the value of the target and, consequently, the acquisition price.

One of the principles in the restructuring of SOEs under the Tentative Procedures is that "the employees' legitimate interests shall not be harmed".¹² The Chinese party of a target SOE is required to consult the representative congress of employees in respect of the restructuring plan.¹³ Where control or the major assets of a SOE are to be transferred to foreign investors, the Chinese party should have an appropriate plan for employee arrangements beforehand and this plan should be examined and approved by the representative congress of the employees of the SOE.¹⁴ Such a plan is also one of the documents to be submitted for government approval and forms part of the acquisition agreement.¹⁵ Moreover, employees who are kept on by the new FIE shall enter into new employment contracts with the new FIE.¹⁶ This may, in certain circumstances, provide the chance of better terms for the employees and increase the operation costs of the new FIE.

How the above provisions will be interpreted by the Chinese authorities and will operate in practice remains to be seen. However, foreign investors should appreciate that these terms may not necessarily work in their favour. The PRC government is wary of social instability, and it has been recognized in particular that SOE employees have not been the major beneficiaries of past SOE restructurings.

Ratio of Foreign Capital

The Tentative Procedures state that they will follow the provisions of the Foreign Investment Industrial Guidance Catalogue (the Catalogue). As such, SOEs in industries in which foreign investment is prohibited are excluded from restructuring activities involving foreign investors.¹⁷ Where Chinese parties are required to hold a "controlling" or "relative controlling" interest under the Catalogue, the new FIE after the restructuring shall also be controlled or relatively controlled by Chinese parties.¹⁸

Apart from the above, the Tentative Procedures do not stipulate the percentage of shares of SOEs that are open to foreign investment, nor the minimum total investment or minimum registered capital requirements for the new FIE after the restructuring. What proportion of shares foreign investors can acquire and what percentage of shareholdings they should maintain in order to qualify as FIEs are hence unclear.

Regulations already issued or pending on this matter are confusing and contradictory. For example, in the Transfer of State Shares and Legal Person Shares in Listed Companies to Foreign Investors Circular, it is stated that listed companies, after the transfer of their state shares and legal person shares to foreign investors, shall not enjoy the same treatment as a FIE, although the new foreign shareholders will be locked into the company for at least 12 months before being allowed to sell shares in it.¹⁹

And matters might become even more complicated. According to reports on the latest draft of MOFTEC's pending Administrative Measures, foreign investors are required, in general, to acquire a minimum 10% of an SOE, 10% to 25% in order to qualify as a FIE, and 25% or more to be entitled to enjoy the preferential treatment for FIEs.²⁰

SOEs subject to restructuring using foreign capital under the above regulations will include not only small- and medium-sized SOEs, but also those ranked as heavyweight players in China's domestic economy. It remains to be seen how much involvement and influence from foreign investors the Chinese government is prepared to accept in these large enterprises.

Acquisition Payments

Under the new regulations, unlisted SOEs are encouraged to use public tendering to select foreign investors and to decide the acquisition price. They can also make private agreements,²¹ which undoubtedly will be the favoured method for foreign investors. In general, foreign investors must pay in hard currency remitted from abroad for any acquisitions. However, in line with well-established regulations and policies, those foreign investors with existing operations in China can pay in local currency if they have profits or have other legitimate assets in China.²²

The entire acquisition price must be fully paid within three months of the date on which the newly established FIEs business licence is issued. Alternatively, if there are "real difficulties" (a concept which the Tentative Procedures do not define further) foreign investors can pay 60% within six months and, subject to the provision of guarantees for the payment, the remaining 40% after no more than one year.²³

The Tentative Procedures provide that, where control of an SOE (or all or the majority of the assets of the SOE) is or will be transferred to foreign investors, and before such time as the foreign investors have paid off the acquisition price in full, the Chinese party shall still have the right to know and to supervise the business operation and financial status of the enterprise.²⁴ This may suggest that foreign investors can take control of the enterprise before they have fully paid off the acquisition price. But foreign investors may question how the "rights to know and to supervise" may be exercised by the Chinese party and whether they may ignore a 1997 MOFTEC circular, which provides that the controlling foreign shareholders will not be allowed "to take control" of the enterprise until they have fully paid off the acquisition price.²⁵

Completion

The acquisition agreement requires approval from the finance department under the Tentative Procedures.²⁶ Such approval may not be made conditional upon subsequent MOFTEC approval of the FIE establishment. Assuming such MOFTEC approval is not merely routine, parties may feel uncomfortable completing the transfer of its interest or assets by the Chinese seller and payment of the acquisition price by the foreign investor prior to the granting of such an approval.

For example, the Chinese seller may be reluctant to initiate approval procedures that may result in the legal transfer of its interest or assets to the foreign investor without receiving the acquisition price in advance or a satisfactory guarantee of payment. Conversely, the foreign investor may not want to pay the acquisition price until the approvals of all relevant government departments have been obtained and both the actual acquisition of the interest or assets and the establishment of the FIE are assured. Experienced foreign investors may also insist, as a condition of payment, on a satisfactory scope of business being granted to the new FIE by the registration authorities.

Simultaneous completion of the acquisition would seem virtually impossible in practice. Various escrow or standby letter of credit arrangements are sometimes designed and used to bridge the gap. Unfortunately, the laws and rules regulating such arrangements are not clear either in China and are still far from routine.

Conclusion

The Tentative Procedures constitute a step forward to facilitate the process of reforming SOEs and demonstrate new openings and opportunities for foreign investors. It is a more significant sign than merely observing the promises China made upon its WTO entry. A landmark policy breakthrough might have been expected to provide the detailed rules that foreign investors have desperately been waiting for. Instead the questions surrounding SOE restructuring still seem to lack measurable guidelines. For the moment, the new regulations may have led to new uncertainties, which in turn reflect the difficulties and limits faced by Chinese lawmakers in navigating an ever changing and complex regulatory landscape.

Endnotes

1 These are the Transfer of State Shares and Legal Person Shares in Listed Companies to Foreign Investors Circular and the Qualifying Foreign Institutional Investors Investing in Domestic Securities Markets Tentative Procedures

2 Article 3.

3 Article 2.

4 Article 18.

5 Article 5 and Article 8(4).

6 Article 9(1).

7 Article 5.

8 Article 9(1).

9 Idem.

10 Articles 9(1) - (2).

11 Article 9(1) - (7).

12 Article 6(5).

13 Article 7.

14 Article 8(2).

15 Article 8.

16 Article 8(2).

17 Article 6(2) of the Tentative Procedures and the Foreign Investment Industrial Guidance Catalogue promulgated by the State Development Planning Commission (SDPC), SETC and MOFTEC, effective April 1 2002.

18 For definitions of "controlling" and "relative controlling" interest see Article 8 of the Guiding the Direction of Foreign Investment Provisions promulgated by the State Council on February 11 2002 and effective as of April 1 2002. Inter alia, "controlling interest" means that the percentages of the Chinese parties' investment in the foreign investment project shall add up to 51% or more; "relative controlling interest" means the sum of the percentages of the Chinese parties' investments in the foreign investment project shall be higher than the percentage of the investment of any one foreign party.

19 Article 7 and Article 9 of the Transfer of State Shares and Legal Person Shares in Listed Companies to Foreign Investors Circular.

20 China Securities Journal, October 22 2002, page 5.

In September 2002, Madam Wu Yi, state councillor and also the former minister of MOFTEC, told a seminar on multinationals' investment to China that the proportion of equities of domestic firms held by foreign investors should be "let go", as long as these domestic firms are not crucial to the viability of China's national economy, or must be controlled by China in accordance with China's relevant commitments.

In the past, 25% of foreign shareholding has been the minimum ratio requirement for qualifying as a FIE and enjoying preferential treatment.

21 Article 8(5).

22 Article 10. This is in line with well-established regulations and practice.

23 Article 11.

24 Article 12.

25 Supplementary Provisions issued by MOFTEC on September 29 1997, paragraph 1.

26 Article 9(2).