SAFE Crackdown: Round-trips, Private Equity and M&A

• Round-trip investments back into China by foreign companies controlled by domestic residents.

The key public document underlying the crackdown is SAFE's Issues Relevant to Improving the Foreign Exchange Administration for Mergers and Acquisitions with Foreign Investment Circular, which was issued on January 24 2005.

A New Focus on Individuals

The Circular is the first formal confirmation that individual domestic residents' foreign currency-related transactions must be approved by SAFE and by the Ministry of Commerce (MOFCOM). Domestic residents, before making investments (directly or indirectly) outside the PRC, must now go through the same examination, approval and registration procedures that have long been required of outward-investing PRC companies. These procedures require the investors to submit an application to SAFE that includes an approval document from MOFCOM (or its local authorized government department), but no such MOFCOM approval documents are likely to be issued until MOFCOM develops its own related policy and guidelines. Before the Circular, PRC individual domestic residents' participation in cross-border transactions fell under a grey area of law,¹ and in practice did not normally need MOFCOM or SAFE approval, despite the existence of a general principle that such approvals were required.²

The definition of a "domestic resident" under previous legislation³ appears to include a foreigner, or a resident of Hong Kong, Macao or Taiwan, who has settled in the mainland or has been physically present in the mainland continuously for more than one year. Hopefully, SAFE will move quickly to clarify that such persons' transactions will not be affected by the crackdown.

Broad Time-frame and Scope

In an unusual departure from the usual "grandfathering" approach, the Circular also now indirectly targets past transactions. When a local SAFE bureau receives a foreign exchange registration application from a foreign-invested enterprise (FIE) previously established through M&A activity by a foreign company owned by PRC residents, the local SAFE bureau must forward the application to SAFE for review. If such an FIE has escaped this review by having already completed its foreign exchange registration, the local SAFE bureau must include the FIE's name on a list of companies targeted to receive special ongoing scrutiny to detect any irregularities.

SAFE personnel have made informal verbal comments that the new approval requirements will apply to investments abroad using funds already held outside the PRC by domestic residents. While SAFE has no way to monitor such investments directly, discovery is likely if they are connected to round-trip investments back into the PRC. It remains unclear whether it is legal for domestic residents to receive foreign currency loans, in accounts outside the PRC from foreign lenders, without SAFE approval. Implementing rules may eventually clarify these points, and are expected to be issued after consultations involving SAFE and MOFCOM.

Round-trips & Offshore JVs

Round-trip investment may account for 20% to 30% of total foreign direct investment into the PRC, according to some unofficial estimates. The long-planned tax reform will reduce one of the attractions of round-trip investment if it eliminates or reduces the difference in income tax rates, holidays and other tax preferences between FIEs and domestically owned enterprises.

But there are other attractions to using offshore joint ventures, between domestic residents and foreign investors, as vehicles to hold PRC subsidiaries. Foreign investors often prefer to arrange for buy-out rights, cash-out opportunities and relations among shareholders to be governed by foreign law and free from the need for PRC government approval. Many offshore jurisdictions do not tax the gain from a sale of company shares. Managers' incentives can be strengthened through shares or share options in offshore jurisdictions. In sum, joint ventures in offshore jurisdictions can follow the venture capital structure and documentation originally popularized in California's Silicon Valley and now used in many international transactions. This is difficult or impossible in China due to less flexible regulations.

Red-chips and Offshore Stock Exchanges

Offshore companies are also able to make public offerings of shares without going through the difficult, slow and selective approval process that applies to PRC companies. Offshore corporate law and listing rules permit such offerings to be structured with a high level of flexibility, e.g., on timing, profitability requirements, percentage of public float, cash-out opportunities, and creation of different classes of shares and/or other securities.

"Red-chip" listings of securities on foreign stock exchanges, by offshore companies mainly acting as holding companies for PRC subsidiaries, have become increasingly popular in recent years. While the first red-chips were owned by major state-owned enterprises, and obtained approvals from the State Council, later imitators were often wholly or partly owned by PRC individuals and were established with few or no PRC government approvals.

SOE Privatization

One of the most sensitive side effects of round-trips and swaps is that they can facilitate, or disguise, privatization of state-owned assets at prices considered by PRC policymakers to be too low. A high official of the State Assets Supervision and Administration Commission (SASAC) recently stated that approvals would be suspended for management buy-outs of large state-owned enterprises and their assets.⁴

PRC policymakers have long sought to obtain high prices from foreign investors for the purchase of a relatively narrow range of state-owned assets, while accepting lower prices from managers and other domestic residents for a relatively broader range of state-owned assets. These goals can be subverted when managers or other domestic residents cooperate with foreign investors through the above swaps, round-trips, etc. PRC managers can use their insider knowledge and relationships to acquire valuable state-owned shares or assets at low cost, and then benefit from an increase in value through the above swaps and round-trips. Foreign investors expecting to benefit from part of this revaluation can provide funding or credit, directly or indirectly, to facilitate the initial acquisition and privatization.

Initial Effects of the Circular

Besides freezing all outbound investments by domestic individuals, the Circular's immediate consequences include freezing of SAFE's processing of M&A applications received from foreign companies owned by PRC domestic residents, while local SAFE branches wait for implementing rules or other guidance. Transactions that are now being delayed include several planned red-chip offerings.

Effect on Strategic Trade Investors

Strategic trade investors, if they would prefer to acquire state-owned companies or assets without significant shareholdings by managers or other domestic residents, may benefit from the crackdown. Besides having access to more investment opportunities, they may enjoy stronger bargaining power when negotiating with state-owned enterprise managers, e.g., on obtaining information about target companies and on the terms of continued employment of managers. The crackdown may also give policymakers and approval authorities additional confidence that, with less risk of later embarrassment or criticism, they can approve the lower prices or other incentives that are often necessary to attract major investments by foreign companies.

Roles of Different Government Departments

The Circular confirms SAFE's growing role in regulating cross-border transactions, and its ability to act unilaterally even in areas that overlap with the responsibilities of other departments, such as MOFCOM and the China Securities Regulatory Commission (CSRC). MOFCOM's future steps will be crucial in clarifying the Circular longer-term impact on all the types of transactions discussed above. MOFCOM is drafting regulations on share swaps between PRC companies and offshore companies (including those controlled by domestic residents, PRC companies or foreign investors). The CSRC may also take additional steps to clarify its policy towards existing and future red-chip listings.

Where to from Here?

The above crackdown is the latest in a long history of policy adjustments. After a period of tightening, we can eventually expect selective loosening. Foreign investors and domestic residents seeking to profit from the acquisition, operation, reorganization, listing and sale of PRC enterprises and assets will also need to apply greater selectivity, patience and creativity.

Endnotes

1 Individual investors were not mentioned in the 1989 Exchange Control for Investments Outside the People's Republic of China Procedures, or even in the much more recent Verification Matters Relevant to Investment in and Establishment of Enterprises Overseas Provisions, issued by MOFCOM with effect from October 1 2004.

2 This general principle was set out in Articles 21 and 22 of the Administration of Foreign Exchange of Individual Residents within China Tentative Procedures, promulgated by SAFE with effect from September 15 1998 and amended on May 1 2003.

3 See ibid.

4 It was reported that Li Rongrong, minister of SASAC, declared on the sidelines of a SASAC work conference in Beijing on January 13 2005 that the central government had expressly prohibited MBOs of large SOEs and would more strongly regulate MBOs of small and medium-sized SOEs. See "Li Rongrong: Central Government Has Made It Clear That No MBOs Will Be Allowed at Large SOEs («???:?????????????????»), " Section 6, People's Daily, January 14 2005.