Giving a Boost to Foreign Equity Participation in Domestic Financial Institutions

Foreign Strategic Investment

The primary interest of foreign banks investing in China lies in the conduct of renminbi (RMB) businesses with Chinese enterprises and individuals. This explains the trend in recent years in which foreign banks have generally preferred to invest in China by way of taking a strategic stake in a domestic bank rather than undertaking traditional forms of investment.²

The permitted business activities of foreign-funded financial institutions are quite restrictive, and hence it has been difficult for them to expand their businesses in China. For example, they are precluded from conducting RMB business and accepting domestic entities and individuals as clients, except where specifically licensed to do so in designated areas.³ In addition, they are not allowed to apply to open branches more frequently than one branch licence per year.⁴ Although they are allowed to raise RMB funds from the domestic interbank market, insufficient RMB funding and the high cost of sourcing RMB from the domestic interbank market continues to put foreign banks at a disadvantage.

Foreign banks that take a strategic stake in domestic banks may avoid these restrictions. Where foreign investment accounts for less than 25%, the domestic bank will remain, for regulatory purposes, domestic in nature, and therefore subject to less stringent regulatory control than typical foreign-funded financial institutions in China. Such foreign banks will also be able to indirectly take advantage of the more extensive network of domestic banks and bypass the many business limitations that are currently applicable to a typical foreign-funded financial institution.

Impact of WTO and CEPA

China's accession to the WTO does not immediately resolve the obstacles to direct foreign investment in the banking industry. Currently, foreign-funded financial institutions are still subject to certain degrees of client restrictions and geographic limitations in conducting RMB businesses. While all of these restrictions will be lifted at the end of 2006 (at which time foreign banks may conduct full RMB business and in theory set up branches anywhere in China), the red tape of case-by-case approvals and the stringent track record and prudential requirements are likely to remain unchanged.

China entered into a Closer Economic Partnership Arrangement (CEPA) independently with both Hong Kong and Macau in the latter half of 2003. While a number of restrictions on direct investment under the WTO framework have been relaxed for CEPA-qualified banks, the preconditions for being so qualified are difficult for most foreign banks to meet. As a result, they are unlikely to benefit under CEPA.

Accordingly, strategic investment continues to be a popular avenue for foreign investment in domestic banks.

Applicability of the Procedures

The Procedures apply to investments made by offshore financial institutions in domestic financial institutions that have been established according to law, including subsequent investments made by an offshore financial institution that already has an existing investment in a domestic financial institution.

Under the Procedures, offshore financial institutions (the acquirers) include both "international financial institutions" (which comprise the World Bank, its institutions, inter-governmental development-oriented financial institutions, and other international financial institutions so recognized by the CBRC) and "foreign financial institutions" (meaning financial holding companies, commercial banks, securities companies, insurance companies and funds registered and established in foreign countries, and other foreign financial institutions so recognized by the CBRC). Foreign-invested financial institutions and foreign bank branches formed in China are excluded from the definition. This qualification echoes existing regulations⁵ that prohibit foreign-funded financial institutions that have been set up in China from investing in domestic financial institutions. The Procedures are also silent as to whether foreign non-financial institutions may invest in domestic financial institutions, despite the fact that existing regulations⁶ apparently allow commercial enterprises to do so.

Domestic financial institutions (the targets) include Chinese commercial banks, urban and rural credit cooperatives, trust and investment companies, enterprise group finance companies, financial leasing companies, and other Chinese-funded financial institutions established upon the approval of the CBRC.

The Procedures do not apply to foreign investment in auto-financing companies and the purchase by qualified foreign institutional investors (QFIIs) of tradable shares in listed domestic financial institutions. However, where foreign investors acquire non-tradable state-owned shares or legal person shares of listed domestic financial institutions, the Procedures will still apply.

Legal Issues Clarified

While the Procedures do not relax the strict approval requirements for foreign investment and equity participation in the financial sector, perhaps the most significant implication of the Procedures is that they acknowledge foreign acquisition of a strategic stake, and further clarify some important legal requirements for such investments.

Maximum Foreign Shareholding Held by a Single Investor

China is keen to strengthen the competitiveness of domestic banks by attracting foreign investment, and yet retaining control of the banks with Chinese investors. Prior to the issuance of the Procedures, an investor who held at least 10% interest in a domestic financial institution was required to obtain the requisite government approval.⁷ In fact, recent transactions where foreign strategic investment has been approved⁸ have revealed that the Chinese authorities would allow a single foreign investor to acquire up to 15% equity interest in a domestic bank.

The Procedures now specify 20% as the maximum shareholding a single foreign investor may acquire in a domestic financial institution, 5% higher than the previously tacit 15%. While this implies that China is now willing to allow foreign investors to gain more control of domestic financial institutions, the recent changes to the Commercial Banking Law (商业银行法)tighten control over changes in shareholders that hold, and changes in shareholdings that amount to 5% (previously 10%) or more of the equity of a commercial bank. The Commercial Banking Law requires such a change to have the prior approval of the CBRC.

Previous approved transactions have indicated that aggregate foreign investment would be limited to no more than 25%,⁹ so that the domestic bank may continue to retain its domestic status. This was done in the interest of foreign banks, as the domestic banks in which they have invested may continue to enjoy a comparative advantage over foreign-funded financial institutions in China in terms of funding, scope of business and client base.

The Procedures do not specify a maximum limit on the aggregate investment made by multiple foreign financial institutions. It is provided that if foreign investment in an unlisted domestic financial institution amounts to 25% or more, the latter will be treated as a foreign-funded financial institution. However, foreign investment of 25% or more in a listed domestic financial institution will not, for regulatory purposes, alter its domestic status.

Preconditions to be met by the Foreign Investor

Prior regulations¹⁰ have specified the qualifications that any investor in a domestic financial institution must meet. The Procedures, for the first time, specifically set out a more detailed set of preconditions a foreign financial institution must satisfy in order to be eligible to invest in a domestic financial institution. The preconditions include:

• as at the end of the immediately preceding year, the foreign institution must have total assets of no less than US$10 billion (if investing in a domestic commercial bank), and no less than US$1 billion (if investing in domestic urban and rural credit cooperatives or non-banking financial institutions);
• in the immediately preceding two years, the foreign institution's long term credit ratings will have been appraised as good by an international rating organization recognized by the CBRC;
• in the immediately preceding two years, it must have been profitable;
• its capital adequacy ratio must not be lower than 8% (for an acquirer that is a commercial bank), or its total capital must not be lower than 10% of its total weighted risk assets (for an acquirer that is a non-banking financial institution);
• it must have sound internal control rules; and
• its place of registration must have comprehensive rules for supervising and administering financial institutions, and the country in which it is located must have a sound economic environment.

The CBRC has wide discretion to adjust these preconditions or impose new conditions on the foreign investor, in light of risks associated with the financial industry and its regulatory requirements.

Approval Requirements

Under previous regulations, prior approval is required from the People's Bank of China (PBOC) for the transfer of equity interest in a financial institution.¹¹ Since the CBRC assumed the regulatory functions of the PBOC, it is now the authority from which such approval must be obtained. Consistent with this understanding, the Procedures specify that foreign investment or equity participation in domestic financial institutions must now be approved by the CBRC.

Where a foreign investor acquires state-owned shares or legal person shares of a listed company (presumably including a PRC domestic bank), the Issues Relevant to the Transfer of State-owned Shares and Legal Person Shares in Listed Companies to Foreign Investors Circular¹² (2002 Circular) provides that additional approvals may be required from the following authorities:

• the SETC,¹³ if the transfer involves industrial policy or restructuring of a listed company;
• the SASAC, if the transfer involves management of state-owned interests;
• the State Council, if the transfer involves major and important issues; and
• the CSRC, if regulations on acquisition of listed companies so require or if disclosure requirements are triggered.

In addition, the Acquisition of Domestic Enterprises by Foreign Investors Tentative Provisions¹⁴(外国投资者并购境内企业暂行规定) (M&A Provisions) that regulate purchases by foreign investors of equity and assets in domestic entities generally require that share transfers be approved by the Ministry of Commerce (MOFCOM).

It is not clear whether the laws and regulations cited above will apply to an equity acquisition of domestic financial institutions by a foreign financial institution, and thereby would trigger additional approval requirements. While the Procedures specify that they will prevail in case of inconsistency with other laws and regulations, they fail to clarify the uncertainty over jurisdictions where there are overlapping regulations on foreign acquisitions in domestic enterprises.

Prior approval from the foreign exchange administration authority (SAFE) may be required if capital account transactions are involved. Pursuant to the 2002 Circular, registration must also be carried out with SAFE before registering any equity transfer of non-tradable state-owned shares and legal person shares in a listed domestic bank.

Application Procedures

The Procedures impose an obligation to obtain CBRC approval in respect of any foreign investment or equity participation in a domestic financial institution. Other than the case where the domestic financial institution is a wholly state-owned commercial bank, a joint stock commercial bank or a non-banking financial institution directly under the supervision of the CBRC where applications must be made to the CBRC directly, such applications may be made to the local branch of the CBRC at the place where it is located.

A number of documents must be submitted at the time of application, including a letter from the domestic financial institution applying to absorb foreign investment. The Procedures also require that "an agreement in the nature of a letter of intent signed by both parties" be submitted. In addition, the board or shareholders' resolutions of both parties (or an approval issued by the higher level government in charge of the domestic financial institution) approving the investment are required. The foreign investor must also provide its annual reports or audited balance sheets, profit statements and other financial statements of the immediately preceding three years, as well as materials concerning the source of its funds and operating conditions. Where the foreign investor is a "foreign financial institution" (as opposed to an "international financial institution"), its credit rating reports for the immediately preceding two years and the approval of the financial supervisory authority at the place of its location must also be supplied.

The CBRC will make a decision as to whether or not to approve the foreign investment or equity participation within three months of receipt of a complete set of application documents. Once approved, the foreign investor must pay the acquisition price in "currency" to the domestic financial institution within 60 days. The domestic financial institution must also attend to relevant procedures if its registered capital or equity structure has been changed as a result of the foreign investment.

Documentation

It is not entirely clear whether the Procedures only require a letter of intent to be submitted as part of the application documents to the CBRC for approval of foreign investment in a domestic financial institution. Typically, the formal transfer/investment agreement is also required for acquisition approvals. For instance, the M&A Provisions require that the equity purchase subscription contract or asset purchase contract (depending on the case) be submitted for government approval.

In any event, the CBRC has the discretion under the Procedures to also require that "other documents", such as the formal acquisition agreement, be submitted for approval.

Pricing and Payment

The Procedures are silent on how the parties are to determine the price of the acquisition. Under the M&A Provisions, an agreed appraisal firm must value foreign acquisitions of assets and shares (whether state-owned or not) according to internationally accepted methods. The valuation will form the basis of determining the purchase price, which must not be significantly lower than the valuation. Although the M&A Provisions do not specifically apply to acquisitions of domestic financial institutions, they mark a trend towards the need for market valuation.

Where state-owned assets are involved, the valuation is to be conducted by firms approved to conduct state-owned asset valuation in accordance with relevant regulations on administration and appraisal of state-owned assets.¹⁵

Where the foreign investor is acquiring state-owned shares or legal person shares in a domestic listed company, the 2002 Circular provides that it should be conducted by way of open bidding, although no mechanism for open bidding has been stipulated.

The Procedures do however specify that payment must be made by way of "currency". This raises the question as to whether foreign investors who already have investments in China would be allowed to pay by way of their RMB dividends derived from such investments. In theory, this should be possible, as it was recognized as a possible mode of payment (subject to SAFE verification) under both the M&A Provisions and the 2002 Circular.

As discussed above, the foreign investor must pay the acquisition price to the domestic financial institution within 60 days of the CBRC's approval on the transfer. This is quicker than that required generally for payment in acquisitions of entities operating in other industries. Under the M&A Provisions, a foreign investor need only pay the purchase price to the seller within three months of the issue of the new business licence of the acquired foreign-invested enterprise.

Other Noteworthy Issues

With respect to the following issues that the Procedures have not addressed specifically, general PRC laws and regulations would apply.

Nature of the Target

General PRC laws (such as the PRC Company Law) detail the conditions and internal procedures applicable to the domestic financial institution if it were to transfer its equity, which vary according to whether it is a limited liability company or a company limited by shares. Existing equity holders of a limited liability company may exercise their pre-emptive rights in certain cases, and lock up periods apply to transfers made by directors and other officers in the case of a company limited by shares. The 2002 Circular specifically forbids foreign acquirers of state-owned shares and legal person shares in domestic listed companies from transferring such shares until a year has lapsed from the date they made full payment of the acquisition price for such shares.

Structure of Acquisition

The Procedures do not set out the ways in which foreign investors may acquire equity in domestic financial institutions. As a general rule, both direct purchase or subscription to increased equity or shares are common methods. Where the target is a listed bank, reforms since late 2002 have allowed foreign banks to acquire either its listed or unlisted shares. While only qualified foreign institutional investors (QFIIs) may purchase (listed) A shares, foreign investors may generally, with relevant government approvals, acquire (unlisted) state-owned shares or legal person shares.

Minority Protection and Exit

Foreign banks will inevitably be concerned with their minority position as a strategic investor in the target domestic bank. Since directors must be elected by the shareholders' meeting, the foreign investor must initially secure the cooperation of other shareholders to propose its director candidates to the board of the domestic bank.

In general, PRC law does not contemplate different classes of shares and most resolutions only require a simple majority vote at both the shareholders and board levels¹⁶ (excepting the case of companies limited by shares that have issued H or N shares outside China and have certain class rights stipulated in their articles of association). It may therefore be difficult for foreign strategic investors to affect decision-making.

Nevertheless, minority shareholders are to a certain extent protected under PRC law, and there are creative ways in which minority protection and management can be enhanced through legal documents. Some successful attempts that have received relevant government approvals include setting out a higher quorum requirement and expanding the statutory list of matters requiring super-majority votes in the relevant constituent documents. The acquisition may also be structured so that the foreign bank initially acquires a modest initial strategic stake while reserving its right to increase its shareholding in future by the exercise of call options and subscription options.

Foreign banks may also enter into management agreements with the target bank as pre-conditions to the acquisition. In particular, they may negotiate for the right to appoint a larger number of directors by concluding a shareholders' agreement. It should be noted, however, that a foreign bank cannot appoint more than half of the board members of a domestic bank since this would be considered as having actual control.

Exit options are also an essential part of legal documentation. They protect foreign investments in difficult times and also allow foreign investors to liquidate their gains when the time is ripe. A common form of contractual exit mechanism is effected by a put option to a pre-agreed party, which may be a pre-existing shareholder (or other third party) or the domestic bank itself. In the former case, the obligated transfer would necessarily be subject to CBRC approval. The latter case is effectively a redemption of shares and hence reduction of registered capital, which again requires CBRC approval. Pursuant to the Company Law, in view of the need to amend the articles of association, such reduction of registered capital must be approved by a two-thirds majority of the shareholders of the domestic bank, regardless of whether it is a limited liability company or a company limited by shares. However, where the domestic bank is listed, the foreign investor has no other exit option but to sell the shares it holds through private agreements (subject to the lock-ups discussed above) or the liquidation of the domestic bank.

Conclusion

The promulgation of the Procedures is a clear improvement to the transparency and efficiency of the legal framework that supports China's policy of encouraging foreign investment in domestic financial institutions. While the Procedures have clarified the application procedures and the preconditions required of the foreign investor, further explanation is needed on the important issues of price and payment, such as how price is to be determined, and in what currency the payment ought to be made. In general, China should also seek to clarify jurisdictional uncertainty among various ministries to help foreign investors to identify, in a particular acquisition, the applicable regulations and relevant government authorities involved.

Endnotes

1 Promulgated by the CBRC on December 8 2003 and effective December 31 2003. See China Law & Practice, February 2004, 18(1), pp. 40-44 for a translation of the law.

2 Traditional forms of investment include branches and joint ventures with domestic banks (where foreign investment is no less than 25%), which are generally referred to as foreign-funded financial institutions.

3 As at the end of October 2003, 84 foreign-invested banks in the form of branches had been approved to conduct RMB business with foreign-invested enterprises and individuals in certain pilot cities. Since December 1 2003, the list of pilot cities has been extended and now includes 13 cities: Shanghai, Shenzhen, Tianjin, Dalian, Guangzhou, Zhuhai, Qingdao, Nanjing, Wuhan, Jinan, Fuzhou, Chengdu and Chongqing. At the same time, foreign banks were allowed to apply to the CBRC to conduct RMB business in China with Chinese enterprises in these pilot cities.

4 Article 14, PRC Administration of Foreign-funded Financial Institutions Procedures Implementing Rules, issued by the PBOC and effective from February 1 2002.

5 Investment and Equity Participation in Financial Institutions Tentative Provisions, issued by the PBOC on July 28 1994 (Yi Fa [1994] No. 186).

6 Ibid.

7 Ibid. This law also stated that the People's Bank of China is the requisite approval authority.

8 The Asian Development Bank's acquisition of 3.29% equity in China Everbright Bank in 1996 was a high profile case of early foreign strategic investment in domestic commercial banks. In a more recent case, the IFC acquired a 15% stake in Nanjing City Commercial Bank in 2001. In late 2002, the Xian City Commercial Bank took on IFC and Scotiabank as strategic investors acquiring a total of a 24.9% stake (12.5% and 12.4%, respectively). At around the same time, the Bank of Shanghai brought in The Hong Kong and Shanghai Banking Corporation (HSBC) and Shanghai Commercial Bank as strategic investors, holding 8% and 3%, respectively. IFC, which was then already an existing investor with a 5% interest in Bank of Shanghai, further increased its investment to 7%. Aggregate foreign investment in Bank of Shanghai now totals 18%. In early 2003, Citigroup acquired a 5% interest in Shanghai Pudong Development Bank, while recently IFC has been approved to acquire a 1.6% stake in Minsheng Bank. Reportedly, the Industrial Bank Co. Ltd has recently entered into contracts to take on Hang Seng Bank (15.98%), IFC (4%) and GIC Special Investments (5%) as strategic investors. If approved by the CBRC, aggregate foreign investment will amount to 24.98%. Approval is still pending.

9 The 25% limit on foreign investment is illustrated in the approved transactions set out in footnote 8 above.

10 See supra note 5.

11 Article 39, Administration of Financial Institutions Provisions issued by the PBOC on August 5 1994 (Yi Fa [1994] No. 198). On commercial banks specifically, Article 24 of the recently amended Commercial Banking Law requires that a change in shareholders holding, or a change in shareholdings of 5% (rather than the previous 10%) or more of the aggregate capital or shares of a commercial bank be approved by the CBRC. Article 7 of the Penalties for Illegal Financial Acts Procedures (issued by the State Council and effective on February 22 1999) provides that PBOC (now CBRC) approval must be sought when there is a change of shareholders, transfer of equity stake or alteration of shareholding structure in a financial institution (note that approval of the relevant finance department is also needed if a change in state-owned shares is involved), failing which a fine may be imposed, and that the senior staff responsible may also receive disciplinary sanctions.

12 Issued by the China Securities Regulatory Commission (CSRC), the Ministry of Finance and the State Economic and Trade Commission on November 1 2002.

13 The SETC was disbanded following a major government restructuring in 2003. Its primary responsibilities have been assumed by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM).

14 Issued by the Ministry of Foreign Trade and Economic Cooperation, the State Taxation Administration, the State Administration for Industry and Commerce and the State Administration of Foreign Exchange, and effective from April 12 2003.

15 See generally the Using Foreign Investment to Reorganize State-owned Enterprises Tentative Provisions, the Administration of State Asset Valuation Procedures, and the Several Issues of Administration of State Assets Provisions. The recently issued Administration of the Assignment of Enterprise State-owned Assets and Equity Tentative Procedures, issued jointly by the State Assets Supervisory and Administration Commission and the Ministry of Finance, which will become effective on 1 February 2004, do not appear to apply to transfer of state-interests in financial institutions.

16 In contrast to FIE laws that apply to entities with 25% foreign investment or more, the Company Law does not mandate unanimity in passing any resolution. The highest voting requirement as set out in the law is only two-thirds for special resolutions.