Acquisition of SOEs in Shanghai: New Rules Open the Market

The regulations referred to above apply to the acquisition of SOEs by foreign investors. Financial and listed SOEs are, however, excluded under both the SOE Reorganization Provisions and the Implementing Rules. Article 3 of the Implementing Rules provides that SOEs refers to companies in Shanghai Municipality that are wholly owned by the state or in which the state has a controlling stake, with the exception of financial companies or listed companies.

Foreign investors are defined in the National SOE Reorganization Provisions to include foreign companies, enterprises, other economic organizations and individuals. Under the Acquisition of Domestic Enterprises by Foreign Investors Tentative Provisions,² a foreign investor may establish an FIE and acquire the assets of the domestic target company by means of the FIE. The Several Opinions and the Implementing Rules, however, expressly provide that foreign investors referred to therein include foreign companies, enterprises, other economic organizations and individuals as well as foreign-invested investment-type companies established in China with the approval of the Chinese government and foreign-invested enterprises that are permitted to make investments (the former are commonly seen as holding companies). While it is clear that holding companies established by foreign investors in China are permitted to make investments, the circumstances are less clear under which a non-investment-type FIE is permitted to acquire an SOE. It is likely that investment activities by a non-investment-type FIE are governed by the Investment within China by Foreign-invested Enterprises Tentative Provisions (jointly promulgated by MOFTEC and the SAIC on July 25 2000), which contains a different set of procedures and requirements for domestic investments by FIEs.

Methods of Acquisition

Pursuant to the National SOE Reorganization Provisions, the acquisition of SOEs can be effected in any of the following ways:

(i) the holder of state-owned properties in an unincorporated SOE sells all or a part of such properties to a foreign investor and the SOE is converted into an FIE;

(ii) the holder of state-owned shares of an incorporated SOE sells all or a part of such shares to a foreign investor and the corporation is converted into an FIE;

(iii) a domestic creditor of an SOE transfers the debts owed to it by the SOE to a foreign investor and the SOE is converted into an FIE;

(iv) an SOE or a corporation with state-owned shares sells all or the major part of its assets to a foreign investor and the foreign investor uses the assets so acquired to establish an FIE on its own or with the seller;

(v) an SOE or a corporation with state-owned shares accepts investment by a foreign investor by way of a capital increase and the enterprise is converted into an FIE.

The above acquisition methods can be characterized as share acquisitions, asset acquisitions or debt-equity conversions.

The methods of acquisition set out in the Implementing Rules include equity transfers and asset acquisitions, but no provision is made for debt-equity conversions. It is not clear whether in Shanghai a foreign investor may acquire an equity interest in an SOE and convert the SOE into an FIE through acquiring the debts owed by the SOE to its domestic creditors. Technically speaking, the National SOE Reorganization Provisions are national departmental rules and are applicable to Shanghai transactions.

Transfer Price and Payment

For any transfer involving state-owned assets, valuation of these assets by an accredited state-owned assets valuation firm is required. Furthermore, the valuation report issued by such a firm is subject to confirmation by the relevant state-owned assets supervision and administration authority. The transfer price is typically negotiated and agreed to by the parties on the basis of the valuation. However, the Administration of Equity Rights Transactions Procedures provide that the sale of state-owned assets shall be based on the appraised value as confirmed by the state-owned assets supervision and administration authority, and that approval from the state-owned assets supervision and administration authority is required if the transfer price is less than 90% of the appraised value.

Under the National SOE Reorganization Provisions, the foreign investor is required to pay the transfer price within three months from the date on which the business licence of the FIE is issued; if there is difficulty in making the payment within three months, no less than 60% of the transfer price may be paid within six months from the date on which the business licence is issued and the remaining 40% shall be paid within one year if guarantee for the payment is provided. The requirements on the time of payment for the transfer price set out in the Implementing Rules are consistent with national legislation, with the exception that no guarantee is required in the case of payment within one year from the issuance of the FIE's business licence. However, if an FIE is established by a foreign investor by way of acquisition of an SOE and conversion of the SOE into an FIE but the foreign investor's subscribed contribution is less than 25% shares of the FIE, under the Implementing Rules the foreign investor is required to pay up the contribution within three months of the issuance of the business licence of the FIE in the case of a cash contribution. Such a requirement is consistent with the Issues Relevant to Strengthening the Administration of Examination, Approval, Registration, Foreign Exchange Issues and Taxation of Foreign-invested Enterprises Circular promulgated by MOFTEC, the State Administration of Taxation, the State Administration for Industry and Commerce and the State Administration of Foreign Exchange on December 30 2002.

Redundant Employees

Traditionally, many SOEs have far more employees on their payrolls than they actually need. The problem of redundant employees often becomes one of the major issues to be dealt with in the acquisition process. Both the National SOE Reorganization Provisions and the Implementing Rules require that, in the case of acquisition of an SOE by a foreign investor, a plan on placement of the employees must be prepared and approved by the workers' congress of the SOE. It is not clear whether the examination and approval authority will approve a transaction if the workers' congress refuses to approve the employee placement plan.

With respect to the obligation to pay salaries and related benefits to the employees, the National SOE Reorganization Provisions provide that the SOE should settle the salaries owed to its employees and social security insurance and other fees owed with its existing assets and that the FIE (which is converted from the SOE) shall enter into new employment contracts with the employees on a voluntary basis. In the event that employment contracts are terminated as a result of the acquisition, compensation must be paid to the relevant employees. If employees are transferred to the social security organization instead of being terminated, social insurance fees shall be paid in respect of such employees in a lump sum. The funds required for payment of the severance compensations and lump sum social insurance fees should be deducted from the net assets of the SOE before the acquisition or be paid on a priority basis by the holder of the state-owned assets from the transfer price.

The Implementing Rules provide that in the event that the employees of the SOE being acquired are terminated or laid off, compensation must be paid in accordance with the Shanghai Municipality, Labour Contract Regulations. However, unlike the National SOE Reorganization Provisions, the Implementing Rules do not specify whether it is the seller or the buyer who has the responsibility for paying such compensation. In the absence of express stipulations in the Implementing Rules, the payment obligation is likely subject to negotiation between the parties. Of course, the foreign investor may take the position that the National SOE Reorganization Provisions are applicable to the transaction and the seller is responsible for such compensation.

Approval Procedures

The procedures for the acquisition of SOEs in Shanghai by foreign investors specified under the Implementing Rules include the following:³

The Filing of an Application with the Foreign Investor Acquisition Comprehensive Services Window. Upon authorization by the Shanghai Municipal State-owned Assets Supervision and Administration Commission, Shanghai Foreign Investment Commission and Shanghai Administration for Industry and Commerce, a comprehensive services window for acquisitions by foreign investors has been established at the Shanghai Equity Exchange. The function of the comprehensive services window is to provide information and consulting services to the acquisition parties, to accept acquisition applications, and to render assistance in connection with asset valuations and equity exchange. A foreign investor who intends to acquire an SOE needs to submit the acquisition application to this unit. Upon acceptance of such application, the comprehensive services window will file the application with the Shanghai Foreign Investment Commission for the record.

Asset Valuation. The acquisition parties should appoint an accredited asset valuation firm to conduct valuation of the assets of the SOE to be transferred. The result of the valuation needs to be submitted to the Shanghai Municipal Asset Valuation and Review Centre for confirmation.

Trading of Equity. The transfer of the equity of an SOE in Shanghai must be carried out at the Shanghai Equity Exchange.⁴ Each of the acquisition parties is required to appoint an accredited broker to organize the equity exchange. The acquisition parties are required to sign the Contract for Entrustment of Equity Transactions in Shanghai Municipality.⁵ The Shanghai Equity Exchange conducts its review of the Contract for Entrustment of Equity Transactions in Shanghai Municipality and other relevant documents, and issues the equity transaction certificate.⁶

Approval by the Shanghai Foreign Investment Commission. Upon the issuance of an equity rights transaction certificate, the acquisition parties will need to, with the assistance of the aforementioned comprehensive services window, submit the application documents to the Shanghai Foreign Investment Commission.

Such documents include:

(i) an acquisition project application report;

(ii) an approval document for the transfer of equity rights of the SOE to be acquired;

(iii) the contract for the establishment of the FIE following the acquisition and the articles of association of the FIE;

(iv) the agreement on the purchase of shares of the SOE;

(v) the equity rights transaction certificate;

(vi) the audit report for the most recent year of the SOE to be acquired;

(vii) the valuation report on the assets of the SOE to be acquired and the confirmation letter;

(viii) the business licences of the SOE to be acquired and the companies invested in by the SOE;

(ix) the certificate of incorporation of the foreign investor and creditworthiness letter in respect of the foreign investor;

(x) explanation of the status of the enterprises invested in by the SOE to be acquired;

(xi) a plan for placement of the employees of the SOE to be acquired; and

(xii) any other documents required.

The Shanghai Foreign Investment Commission makes its decision within 10 working days upon receipt of the required documents. Following the approval by the Shanghai Foreign Investment Commission, the acquisition parties will need to apply to the relevant administrative bureau for industry and commerce for registration and handle the cancellation of the registration of state-owned equity and registration for the change of the ownership of the relevant properties.

Conclusion

The National SOE Reorganization Provisions and the Implementing Rules have provided a basic legal basis for the acquisition of SOEs by foreign investors. The Implementing Rules have set out more detailed procedures for the acquisition of SOEs in Shanghai. Both regulations allow the flexibility of acquisition of assets or the acquisition of equity interests. Due to the difficulty in identifying potential liabilities of the SOEs, most foreign investors may opt for asset acquisitions. The requirement of approval of the plan for placement of the employees and the responsibility for payment of severance compensations to the employees to be laid off as a result of acquisition may prove to be a difficult problem to tackle. In addition, there are ambiguities and inconsistencies in the various regulations issued by different authorities. Such ambiguities and inconsistencies will hopefully be sorted out in further legislation. Failing that, they will need to be sorted out in practice.

Endnotes

1 For a full translation of the law, see China Law & Practice, October 2003, 17(8), pp. 55-61.

2 The Acquisition of Domestic Enterprises by Foreign Investors Tentative Provisions apply to the acquisition of domestic companies (other than FIEs) by way of share transfer or asset acquisition.

3 Pursuant to Article 9 of the Using Foreign Investment to Reorganize State-owned Enterprises Tentative Provisions, approval by the Ministry of Commerce is required if the acquisition affects the controlling stake in an enterprise under the central government or its wholly owned subsidiary, or the SOE to be acquired holds, directly or indirectly, the shares of a listed company or the total assets of the enterprise exceeds US$30 million after the restructuring. If the acquisition may lead to a possible monopoly or impede fair competition, pre-approval hearing is required.

4 The Administration of Equity Rights Transactions Procedures provide that the trading of state-owned equity or collectively owned equity within the jurisdiction of Shanghai must be carried out at the Shanghai Equity Exchange and that the trading of other equity may be carried out at the Shanghai Equity Exchange.

5 In the case of acquisition of SOEs by way of equity transfer or asset acquisition, the Shanghai equity transaction contract could mean either an equity transfer contract or asset purchase contract. However, a standard contract is required to be used although the provisions in the form contract may be altered according to the circumstances by the schedules attached to the form contract.

6 Under current practices, the trading of equity at the Shanghai Equity Exchange is carried out after the approval of the transaction by the Shanghai Foreign Investment Commission or, in the case of a total investment of less than US$5 million, the foreign investment approval authority at the district level.