Filling the Gap: Foreign Acquisitions in the Publishing Distribution Sector

Each of these legal developments means investors in China face unprecedented changes, and all taken together mark a positive step in opening the economy to foreign investment. Despite the good news, however, how implementation of the legislation actually occurs will shape the landscape of foreign investment. Here we will examine the interaction between the new measures guiding foreign investment in the book distribution sector and the recent legislation on mergers and acquisitions (M&A) activity involving foreign investment in practice.

Bertelsmann¡¯s Landmark Joint Venture

In December 2003, Beijing 21st Century Book Chain Co., Ltd. (北京二十一世纪绵绣图书连锁有限公司) became the first Sino-foreign book distribution joint venture to be approved for business pursuant to the FIE Distribution Procedures. Beijing 21st Century, a locally owned private enterprise, has long been a well-known name in the book retail sector and was selected by the General Administration of Press and Publication (GAPP),⁴ the publishing industry authority, on this basis as an approved national chain operator.

Following the guidelines provided by the Acquisition Tentative Provisions, Bertelsmann acquired a significant stake in the local company, the target local company¡¯s original shareholder remained as a Chinese party to the joint venture, and the company was converted into a Sino-foreign equity joint venture. Finally, the joint venture was granted approval to set up chain stores nationwide, subject to the geographical restrictions established by China¡¯s commitments during its accession to the World Trade Organization.

The process of establishing this landmark joint venture required extensive scrutiny of the new legislation as well as unprecedented coordination among the relevant government authorities. In retrospect, the case illustrates both the details of the application and approval procedures mandated by the new legislation, as well as the unforeseen ambiguities and legislative gaps resulting from the interaction of the authorities during the implementation process.

GAPP¡¯s Role in Approving Distribution FIEs

The GAPP has long overseen the publishing sector in China, including the implementation of industry reform and the promulgation of new legislation to facilitate such reform. The FIE Distribution Procedures require that investors proposing to establish foreign-invested enterprises for the distribution of books, newspapers or magazines obtain approval from both the GAPP and the Ministry of Commerce (MOFCOM).⁵

The opening of the doors of China¡¯s bookstores to foreign investors comes after a long period during which book distribution was monopolized by the Xinhua network. Before 2000, the majority of book publishers in the PRC were state-owned entities and depended on state funding, quota systems for book sales and the Xinhua distribution network (also known as the ¡°First Channel¡±) for distribution.⁶

The 1999 Administration of the Publications Market Tentative Provisions⁷ to a degree reflected emerging private sector participation in the distribution sector, although these provisional rules confirmed the state-owned enterprises¡¯ dominance of the market. However, new legislation issued last year ¨C the Administration of the Publications Market Regulations (2003 Publications Market Regulations)⁸ ¨C replaced those rules and eliminated any preferential treatment for state-owned enterprises. This development reflects recent policy shifts within the Communist Party of China and the GAPP that have encouraged the commercialization of the business aspects of publishing.⁹

Now, more publishers are selling their products via the so-called ¡°Second Channel¡± in China, which consists of a wide variety of private bookstores and sales agencies that have grown over the past few years. Moreover, some publishing houses with internal circulation departments are contemplating ways to spin off these departments into independent distribution companies. Overall, distributors are seeking funding and resources from various new sources, including local private investors, major publishing houses and even foreign investors.

To establish a company under the FIE Distribution Procedures, an application letter and project proposal (or feasibility study) must be submitted to the local (provincial-level) branch of the GAPP, together with each investor¡¯s business licence and bank reference letter. The local branch of the GAPP conducts a preliminary examination, and a timeframe of 45 business days is allotted for the process of evaluation, reporting and endorsement between the local and central GAPP.

Although the applicant must primarily deal with the local GAPP, a direct dialogue and coordination with the central GAPP is both necessary and helpful in certain circumstances. In establishing a direct channel for communication, the applicant need not rely on the local GAPP to relay any explanation accompanying the application to the central-level authority. Both of the GAPP departments that were responsible for drafting and interpreting the FIE Distribution Procedures ¨C the Department for Foreign Exchange and Cooperation and the Distribution Department ¨C must sign off on each application at the central level.

After obtaining GAPP approval, applicants to establish an FIE for publications distribution must apply to MOFCOM for approval, via its local (provincial-level) branch. The approval must be provided within 45 business days and will be proven by a Foreign-Invested Enterprise Approval Certificate. Within 90 days of obtaining MOFCOM¡¯s approval, the investor(s) must also obtain a Publications Operating Permit from the local branch of the GAPP and a business licence from the local Administration of Industry and Commerce (AIC).

GAPP¡¯s Attitudes toward the WTO Timeline

The FIE Distribution Procedures codify the commitments made by China during its accession to the World Trade Organization (WTO). While current legislative trends suggest that all editorial aspects of the publishing industry will remain closed to foreign participation indefinitely, the GAPP¡¯s implementation of the FIE Distribution Procedures demonstrates that China is making a good faith effort to stick to its WTO commitments in this sector.

The March 2002 revision to the Foreign Investment Industrial Guidance Catalogue (the Catalogue) unequivocally states that foreign investment in the ¡°publication, general distribution and import of books, newspapers and periodicals¡± is prohibited, but that the distribution business will gradually open to foreign investment in keeping with China¡¯s commitments for its accession to the WTO.

Per China¡¯s WTO commitments, the FIE Distribution Procedures set forth detailed requirements for establishing foreign-invested retail and wholesale distribution enterprises, including establishing new Sino-foreign joint ventures, forming joint ventures via the acquisition of existing local companies and incorporating wholly foreign-owned enterprises, subject to certain geographical restrictions. The same corporate structures will be made available for wholesale distribution on December 11 2004.

As majority foreign investment in retail and wholesale distribution enterprises would not be permitted until December 11 2006 under the WTO commitments, the FIE Distribution Procedures open the retail sector to majority, and even 100%, foreign ownership far ahead of schedule. According to the GAPP¡¯s Department for Foreign Exchange and Cooperation, retail distribution enterprises established under the FIE Distribution Procedures are still subject to the geographic restrictions set forth in China¡¯s WTO accession agreements.¹⁰

Ongoing Discussions on Chain Store Operations

Chain store operations are an area of keen interest for foreign investors. Indeed, the inevitable thought on everyone¡¯s mind upon hearing the news of the opening of the book distribution market to foreign investment is how long it will be before there is a Barnes & Noble on every street corner in China.

The first legal reference in this area is the Development and Standardization of the Operations of Chain Stores for Publishing Distribution Several Opinions, which was issued by the GAPP in 2002 (Document No. 886).¹¹ This law stated that GAPP must approve the establishment of joint ventures for distribution in the publishing industry. Also, prior to November 2006, where any such joint venture opens more than 30 stores, the Chinese party shall hold the majority stake.

Secondly, the categorization of chain store operations, vis-¨¤-vis retail and wholesale categories, remains under debate within the GAPP. The 2003 Publication Market Rules, which were not issued until July 2003, or mid-way through Beijing 21st Century¡¯s application, are the key legal reference in terms of the order and hierarchy of the publications market. They define chain store operations independently of the retail and wholesale categories, stipulating that an entity operating chain stores must have a registered capital of at least Rmb3 million, at least 10 stores operating under its name and a flagship store with a business area of no less than 500 square metres.¹²

Thus, during the application process for its conversion into a joint venture, Beijing 21st Century engaged in ongoing consultations with the GAPP on the chain store issue and ultimately gained approval to engage in nationwide chain store operations.

During those discussions, the applicant obtained additional guidance on the implementation of the FIE Distribution Procedures from the two GAPP departments. For example, the Department for Foreign Cooperation and Exchange maintained that there would be no limitations on chain store operations, save for those geographical limitations imposed by the WTO commitments. At the same time, the Distribution Department of the GAPP expressed its inclination for the comparatively restrictive interpretation that applications to establish nationwide chain store operations will be treated as applications to establish wholesale publications enterprises, which will be open to foreign investment after December 1 2004. This ongoing discussion reflects the legislative gap between FIE Distribution Procedures and the 2003 Publication Market Rules.

Thirdly, the 2003 Publication Market Rules outline the procedures for the opening of additional stores by companies approved to engage in chain store operations. Such companies need not apply for a new Publications Operating Permit for each store. Rather, the company is simply required to apply to the local AIC to secure a business licence for the store on the basis of the company¡¯s permit, and need not deal directly with the GAPP¡¯s local arms in each locality.¹³

MOFCOM¡¯s Dominant Role in Interpreting the M&A Rules

Article 2 of the FIE Distribution Procedures specifically permits foreign equity investment in existing licensed domestic enterprises through the ¡°purchase of shares in or the merger with or acquisition of domestic enterprises¡±.

The issuance of the FIE Circular at the end of 2002 represented the first in a series of steps by the relevant Chinese government authorities to standardize and clarify the approval process and equity transfer rules for FIEs. Specifically, the Circular introduced stricter time limits for foreign investors¡¯ payment for equity acquired in a domestic company (three months); limitations on the assumption of management rights by the foreign investor until full payment has been made; a broader definition of FIEs that includes companies with less than 25% foreign investment; and an allowance for Chinese individuals to remain as a shareholder post-acquisition, provided that he has been a shareholder for at least one year, subject to approval.

Similarly, the Acquisitions Tentative Provisions address various forms of both equity and asset acquisitions where the target company is a domestic enterprise.¹⁴ All such acquisitions require the approval of MOFCOM or its provincial-level branch,¹⁵ and the consideration paid under all such acquisitions should be determined either based on negotiations between the parties or with reference to an appraisal of the target company or its assets by an appraisal institution licensed in the PRC.¹⁶ (This process is not entirely straightforward, though. See the discussion below regarding the ambiguities of this requirement for the determination of the transaction price.) In addition, a number of detailed rules are included that address areas including creditors¡¯ rights, recognition of payment in the form of disposable stock and antitrust matters.

In some ways, though, these two pieces of legislation have led to as many new questions as they have resolved. We cite below a number of questions, and the preliminary answers that we have gotten based on the Beijing 21st Century test case.

As the continuing status as a shareholder by an individual is ¡°subject to approval¡±, what will be the specific criteria for granting such approval?

The chairman of Beijing 21st Century, who had been a shareholder of the company for more than one year, had negotiated with Bertelsmann to retain his shareholder position and serve as a ¡°Chinese party¡± to the joint venture. Based on a quick acceptance of this aspect of the application by both the Beijing Bureau of Commerce and MOFCOM thereafter, it seems that this concept of an individual shareholder will not be treated as a special case but in fact is well accepted among foreign-investment authorities.

Will central-level MOFCOM approval be required for all foreign acquisitions in the print media sector, or will local-level approval be sufficient in certain cases?

The Acquisitions Tentative Provisions introduce a two-tiered examination and approval involving both MOFCOM and its provincial-level branch for applicants that, ¡°pursuant to laws, administrative regulations or departmental rules or regulations, are of a particular type or in a particular industry that requires the examination and approval of MOFCOM¡±.¹⁷ Thus, as mandated by the FIE Distribution Procedures, MOFCOM shall make the final decision for all M&A activity in the print media sector. Clearly, this requirement is dictated by the GAPP and not MOFCOM.

MOFCOM approval was thus obtained in the Beijing 21st Century venture. However, it remains to be seen whether minor investment activity in the print media sector (such as foreign investment in an individual retail bookstore in a single city) will indeed be required to obtain central-level MOFCOM approval. As foreign investment in most industries requires only local-level MOFCOM approval, such a requirement may prove difficult and may generally serve as a deterrent to investment.

Will a private company¡¯s stake be subject to certain valuation standards, or can the value be determined between the parties through commercial negotiations?

Article 8 of the Acquisitions Tentative Provisions states:

The parties to an acquisition shall determine the transaction price on the basis of the value of the equity to be transferred or the value of the assets to be sold as appraised by an asset appraisal institution. The parties to the acquisition may agree on an asset appraisal institution established in China in accordance with the law.

If the acquisition of a domestic enterprise by a foreign investor will lead to a change to the equity resulting from an investment of state assets or a transfer of title to state-owned assets, an appraisal shall be conducted in accordance with provisions on the administration of state-owned assets in order to determine the transaction price.

This article leaves investors wondering about the extent to which the transaction price can be negotiated between the parties (particularly if no state-owned assets are involved) and whether it will be subject to certain valuation standards.

In the Beijing 21st Century case, as the target company was originally a private company, no outside appraisal of the company¡¯s value was undertaken; the parties reached an agreement on the value based on commercial negotiations. The resulting transaction price was accepted by the GAPP and MOFCOM. Apparently, the authorities tend to exclude private stakes in domestic companies from such appraisal requirements.

Conclusion

Apart from the aforementioned questions raised about the nature of M&A activity in the print media industry, a number of interesting technical issues have also been uncovered. Further, as more FIEs are approved in this sector, other practical issues promise to be raised.

For example, the FIE Distribution Procedures state that an FIE¡¯s business licence should be issued by the local AIC after the Foreign-Invested Enterprise Approval Certificate has been obtained from MOFCOM. However, based on our experience, the Beijing AIC is reluctant to issue such a business licence when central-level MOFCOM has granted the approval for the establishment of the FIE, as this contradicts internal rules that would require the state AIC¡¯s waiver for the same. Thus, it is likely that the business licence will be issued instead by the state AIC, which may take a considerably longer period of time to complete and may also make matters more complicated for the future business operations of the FIE.

Another example is the question of online sales of publications. Following the approval of Beijing 21st Century¡¯s conversion into an FIE, a number of retail distribution joint ventures have now been approved (primarily with only one store each and therefore not leading to a chain store debate). It is reasonable to expect that the question of online sales will be raised in relation to the establishment of retail joint ventures, and it will be interesting to observe how the GAPP and MOFCOM interpret online sales within the scope of retail FIEs. Any enterprise engaging in e-commerce activities must liaise directly with the Ministry of Information Industry (MII), as the MII is charged with regulating the value-added telecoms sector, including e-commerce. However, the FIE Distribution Procedures do not address this issue of coordination with the MII; rather, in the same non-committal fashion in which chain store operations are addressed, they merely state that distribution FIEs ¡°which conduct business relating to online sales¡± shall handle their application and approval procedures in accordance with the requirements of the FIE Distribution Procedures.¹⁸ At present, the MII limits foreign investment in value-added telecoms JVs to 50%, which is significantly lower than the level of foreign involvement permitted in the distribution sector. Thus, applicants should seek additional clarification from the GAPP and MII on this issue.

As illustrated above, industry developments are proceeding as quickly, if not faster than, the overall regulatory framework for the print media industry. We can reasonably expect that the GAPP, MOFCOM and other related authorities will continue to clarify and update the legislation in this sector in order to adapt and change with the industry. Only through this process can a more seamless coordination between these authorities be accomplished to facilitate the growth and development of the industry.

Endnotes

1 The rules were promulgated on March 17 2003 by the General Administration of Press and Publication and the then Ministry of Foreign Trade and Economic Cooperation (MOFTEC) as Decree No. 18, effective as of May 1 2003.

2 Issued on December 30 2002 by MOFTEC, the State Administration of Taxation, the State Administration of Industry and Commerce and the State Administration of Foreign Exchange, and effective as of January 1 2003. See China Law & Practice, February 2003, 17(1), pp. 57-60 for a translation of the law.

3 Promulgated on March 7 2003 by MOFTEC, the State Administration of Taxation, the State Administration of Industry and Commerce and the State Administration of Foreign Exchange, and effective as of April 12 2003. See China Law & Practice, April 2003, 17(3), pp. 27-39 for a translation.

4 Although still widely referred to as the State Press and Publication Administration (SPPA), the publishing industry authority was transformed in 2001 into a ministerial-level organization and renamed the General Administration of Press and Publication (GAPP).

5 During the recent government restructuring that was implemented pursuant to the National People¡¯s Congress in March 2003, the State Economic and Trade Commission and MOFTEC were merged into a new government agency, the Ministry of Commerce (MOFCOM).

6 The Xinhua network has traditionally operated through provincial-level groups of chain stores and was responsible for selling more than 60% of books in the PRC up until about 2000. In 1991, Xinhua was named in legislation as the designated general distributor of books at the provincial level.

7 Promulgated on November 22 1999 by the SPPA.

8 Promulgated on July 24 2003 by the GAPP as Document No. 20, effective as of September 1 2003.

9 Specifically, Article 4 of the 2003 Regulations states only that the GAPP is responsible ¡°for the formulation of planning with regards to the development of the national distribution industry for publications¡±; there is no reference to Xinhua or even to a preference for state-owned enterprises.

10 In keeping with China¡¯s WTO commitments, as of December 11 2002, book, newspaper and magazine retail distribution markets were open to foreign investment in five special economic zones (Shenzhen, Zhuhai, Shantou, Xiamen and Hainan) and eight major cities (Beijing, Shanghai, Tianjin, Guangzhou, Dalian, Qingdao, Zhengzhou and Wuhan). As of December 11 2003, the retail distribution markets in all provincial capitals as well as in Chongqing and Ningbo are also open to foreign investment. By December 11 2004, all geographical restrictions and investment limits will be lifted. See World Trade Organization, Report of the Working Party on the Accession of China, Addendum: Schedule CLII - People¡¯s Republic of China, Part II - Schedule of Specific Commitments on Services, List of Article II MFN Exemptions, October 1 2001.

11 Issued on August 5 2002 by the GAPP as Document No. 886.

12 2003 Publication Market Rules, Article 12. There is no stated minimum registered capital for domestic retail enterprises, while the minimum registered capital for domestic wholesale enterprises is Rmb2 million (Article 8). In comparison, under Articles 7 and 8 of the FIE Distribution Procedures, the minimum registered capital for a foreign-invested retail enterprise is Rmb5 million, while that for a foreign-invested wholesale enterprise is Rmb30 million. The FIE Distribution Procedures do not list a separate minimum registered capital for chain store operations.

13 2003 Publication Market Regulations, Article 14.

14 Acquisitions Tentative Provisions, Article 2. An ¡°equity acquisition¡± is defined as a ¡°purchase by agreement of the equity of a shareholder in an enterprise other than a foreign-invested enterprise (a Domestic Company) or subscription to a Domestic Company¡¯s capital increase, resulting in the conversion of the Domestic Company into a newly established foreign-invested enterprise¡±. An ¡°asset acquisition¡± is defined as ¡°a foreign investor¡¯s establishment of a foreign-invested enterprise and purchase by agreement, through such enterprise, of the assets of a domestic enterprise and operation of such assets, or a foreign investor¡¯s purchase by agreement of the assets of a domestic enterprise and use of such assets, or a foreign investor¡¯s purchase by agreement of the assets of a domestic enterprise and use of such assets to invest in and establish a foreign-invested enterprise to operate such assets¡±.

15 Ibid, Article 6.

16 Ibid, Article 8.

17 Ibid, Article 6.

18 FIE Distribution Measures, Article 18.