New Rules on Strategic Investments by Foreign Investors in Listed Companies

No cap on foreign participation

A foreign strategic investor must acquire a minimum of 10% of all the shares of the target listed company. Circular 28 does not set a foreign shareholding cap on strategic investments, but as a general requirement, the strategic investment must comply with the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录)as well as with the ceiling percentages set out in any industry-specific regulations.

However, foreign strategic investments can only be made in the few listed companies that have so far fully implemented the Reform.⁶ Also, the shares acquired by a foreign strategic investor under Circular 28 whether by private share transfer or private placement are subject to a three-year lockup period (compared with one to three years for QFIIs), except in circumstances specifically approved by the Ministry of Commerce (MOFCOM). After the three-year lockup period expires, if the foreign strategic investor wishes to exit the listed company, the listed company must obtain MOFCOM's approval regarding the change of its share capital structure.

Strategic investors' qualifications

When first introduced in Circular 565, the concept of strategic investment may have led some to think that onerous qualification requirements would be imposed on strategic investors. On the contrary, Circular 28 introduces requirements that are surprisingly investor-friendly. In terms of quantitative requirements, the foreign investor (or its holding company) must own offshore assets of at least US$100 million or manage offshore assets of at least US$500 million. The strategic investor must be an existing legal corporate entity or other form of organization, and must also comply with a range of prudential conditions that are standard in PRC regulations.⁷

As an additional move in the right direction, Circular 28 expressly allows a foreign investor to make a strategic investment in a PRC-listed company through a "wholly-owned subsidiary located outside China", even where the subsidiary would not itself comply with the qualification requirements. In this case, the parent company must commit itself to take joint and several liability with its wholly-owned offshore subsidiary.

Share transfer or private placement?

Under Circular 28, a strategic investment in a listed company by a foreign investor can be performed:

(i) by a private share transfer agreement between existing shareholder(s) and the foreign investor;

(ii) by a private placement by the listed company to the foreign investor, or

(iii) by "any other method as allowed by PRC law".

Other than specific references to acquisition by share transfer or by private placement, Circular 28 is silent as to the nature of the other methods which could be used to achieve a strategic investment. Interestingly, the PRC Securities Law(中华人民共和国証券法), which came into effect on January 1 2006, uses a similar expression and refers to a general takeover offer as "a method allowed by PRC law". However, it is unlikely that foreign strategic investors will be able to purchase a significant stake directly in the secondary market, at least in the short term.

Despite the new opportunities offered by Circular 28, foreign investors will find it extremely difficult, in the next three to four years, to obtain controlling stakes in PRC-listed companies by private share transfer. Indeed, the transfer of shares recently floated on the Shanghai and Shenzhen stock exchanges as a result of the implementation of the Reform ('G-shares', from gai ge, the Chinese word for reform) since April 2005, will be subject to a full one-year lockup period.⁸ In the 12 months following the end of this lockup period, holders of G-shares will only be allowed to trade up to 5% of the company's total shareholding, and up to 10% in the following 24 months. Only after these three years will holders of G-shares be able to transfer significant controlling stakes to foreign investors.

In the meantime, strategic investments will need to find a way through private placements. Article 13 of the PRC Securities Law(中华人民共和国証券法)provides that listed companies privately issuing new shares to a designated investor must comply with conditions set in regulations issued by the China Securities Regulatory Commission (CSRC). Until these detailed regulations on private placements are issued, which is expected to happen in the first half of 2006, general guidance on private placements will be found in Circular 28 and in the PRC Company Law(中华人民共和国公司法), which came into effect on January 1 2006.

Dual general offer requirement

Under Circular 28, only an acquisition by share transfer, which results in the foreign investor becoming the effective controlling shareholder of the listed company, is subject to the general offer requirement. However, if an acquisition by private placement results in the foreign investor becoming the effective controlling shareholder of the listed company, the acquisition would be subject to a general offer requirement under the PRC Securities Law(中华人民共和国証券法). In this case, the strategic investor can apply to CSRC for a waiver of the general offer obligation under the Measures for Administration of the Takeover of Listed Companies (Takeover Measures), which came into effect on December 1 2002. However, it remains to be seen how CSRC will handle such an application.

Unfortunately, Circular 28, the PRC Securities Law(中华人民共和国証券法) and the Takeover Procedures refer to different general offer trigger events. Article 9 of Circular 28 refers to 'effective control' as the trigger of the general offer requirement, while the PRC Securities Law(中华人民共和国証券法) and the Takeover Measures both refer to a 30% shareholding. Consequently, even without reaching 30%, foreign investors obtaining 'effective control' as a result of a strategic investment may be required to satisfy the requirement to make a general offer.

acquisition Payment

The greatest concern arising out of Circular 28 is the apparent lack of flexibility regarding the method of payment for the acquisition. Pursuant to Article 14, the payment of the acquisition price must be made in foreign currency and no other payment method is mentioned. Although Circular 28 provides for the possibility of paying by instalments, foreign investors should take note that the transaction must be completed within 180 days of receiving MOFCOM's approval.

Considering the PRC's longstanding preoccupation with attracting and controlling foreign exchange, payment with the foreign strategic investor's own shares does not seem to be a possibility under Circular 28, despite the fact that Article 9 of the Merger with and Acquisition of Domestic Enterprises by Foreign Investors Tentative Provisions⁹ provides that a foreign investor, with the approval of the foreign exchange control authorities, may use shares over which it has the right of disposal as a means of payment for an acquisition. References to payment with shares are also found in the Takeover Measures.¹⁰

It remains to be seen how Circular 28 will interact with the forthcoming cross-border share swap regulations.¹¹ Although these regulations have not been promulgated yet, it is expected they will only allow for shares of PRC entities to be exchanged against shares of overseas listed companies or shares of offshore special purpose vehicles established by domestic companies for the purpose of offshore listing.

Two-tier FIE-status

Circular 28 reiterates the pre-existing distinction between partial and full foreign-invested enterprise (FIE) status, depending on the foreign participation in the listed company. If a foreign strategic investor holds 25% or more of a listed company and commits itself to retain at least 25% in the subsequent 10 years, the listed company will be granted full FIE status. Unfortunately, tax preferential treatment, which is the major interest of holding the FIE status, is unlikely to benefit listed companies with full FIE status.¹²

Listed companies with foreign shareholdings between 10% and 25% will only partially qualify as FIEs and will be treated as domestic companies in a broad range of circumstances, for example, when contracting foreign debt or when conducting foreign exchange transactions. Listed companies must apply for the cancellation of their FIE status if their foreign participation falls below 10%.

Looking ahead

The introduction of the strategic investment concept is undoubtedly a significant development which will considerably encourage M&A activity involving PRC-listed companies. It provides a much better alternative to QFIIs, which are of limited use to foreign investors wishing to hold a significant stake in a target listed company. However, the level of activity will remain difficult to predict until a greater proportion of the companies listed on the Shanghai and Shenzhen stock exchanges have implemented the Reform. In the meantime, PRC regulators are expected to issue rules on cross-border share swaps and on private placements by listed companies. Together with Circular 28, these forthcoming regulations will further boost M&A activity involving PRC-listed companies.

Endnotes

1 Circular 28 was jointly issued by the Ministry of Commerce (MOFCOM), the China Securities Regulatory Commission (CSRC), the State Administration of Taxation (SAT), the State Administration of Industry and Commerce (SAIC) and the State Administration of Foreign Exchange (SAFE) on December 31 2005, effective January 30 2006.

2 Matters Relevant to the Administration of Foreign Capital Involved in the Reform of the Division of Equity Interests of Listed Companies Circular (Circular 565 - jointly issued by MOFCOM and CSRC, effective October 26 2005).

3 On April 29 2005, CSRC launched a pilot reform according to which non-tradable shares in selected companies were floated on stock exchanges in Shanghai and Shenzhen as tradable shares held by public shareholders. On September 4 2005, CSRC issued the Administration of Listed Companies Stock Right Allocation Reform Method, extending the Reform to all listed companies.

4 Administration of Investments in Domestic Securities by Qualified Foreign Institutional Investors Tentative Regulations (jointly issued by CSRC and the People's Bank of China on November 5 2002, effective December 1 2002).

5 Matters Relevant to Foreign Investment in Listed Companies Several Opinions (jointly issued by MOFCOM's predecessor, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) and CSRC, effective November 8 2001); Matters Relevant to the Transfer of State-owned Shares and Legal Person Shares in Listed Companies to Foreign Investors Circular (jointly issued by the CSRC, the Ministry of Finance (MOF) and the former State Economic and Trade Commission (SETC), effective November 1 2002).

6 As of February 7 2006, only 57 of the 833 companies listing A-shares on the Shanghai Stock Exchange (SSE) have implemented the Reform and another 52 companies have notified the SSE of their intention to do so. These numbers are likely to increase in the short term.

7 These prudential conditions are: "having financial stability and be of good standing"; "having conducted operations in a lawful way"; having established "complete corporate governance and internal control systems", and having "no record of material penalty being imposed by any regulatory authority" either in its domestic jurisdiction or any other jurisdiction during the three years preceding the strategic investment.

8 The decision to take advantage of the Reform rests with the listed company's holders of non-tradable shares: at least two-thirds of holders of non-tradable shares must put forward a joint motion requiring the company's board of directors to convene a shareholders' meeting. The decision to float the company's non-tradable shares must then be approved by two-thirds of all shareholders (including two-thirds of holders of tradable shares) attending the shareholders' meeting.

9 These provisions were jointly issued by MOFCOM, SAT, SAIC and SAFE, effective April 12 2003.

10 Article 35 of the Takeover Measures.

11 MOFCOM, SAIC and SAFE are currently jointly engaged in the drafting of regulations on the cross-border exchange of shares between domestic and foreign companies. A draft version of the regulations was circulated in April 2005.

12 Under the Matters Relevant to the Transfer of State-owned Shares and Legal Person Shares of Listed Companies to Foreign Entities Circular (jointly issued by CSRC, the Ministry of Finance and the State Economic and Trade Committee on November 1 2002), listed companies with a foreign shareholding exceeding 25% are not entitled to the preferential tax treatment granted to FIEs. Despite that SAT took part in the drafting and issuance of Circular 28, the circular does not indicate whether the tax treatment will be different for a listed company where a foreign investor holds more than 25% of the shares as a result of a strategic investment. However, it is likely that the same principles will apply and that no preferential tax treatment will be available.