Acquisition of Domestic FMCs by Foreign Investors Part II

In order for foreign financial institutions to effectively control risks associated with their proposed acquisitions of domestic FMCs, it is vital that overseas financial institutions conduct detailed due diligence on target FMCs when undertaking an acquisition. It is important for the acquiring institution to work with a law firm that is experienced in acting as legal counsel and/or long-term advisors to FMCs, since such firms have a solid understanding of the FMCs (from formation to operation of these FMCs) and the PRC market. An experienced law firm will be able to clearly and speedily identify the critical issues for their clients in the due diligence process.

Applicable Law

In the past, as foreign financial institutions were not familiar with Chinese law and lacked confidence in the Chinese legal system, they usually required equity transfer agreements to be governed by foreign law. On August 8 2007, the Supreme People's Court of China promulgated and implemented Provisions on Several Issues Concerning the Application of the Law in the Trial of Foreign-related Civil and Commercial Contract Disputes (See China Law & Practice September issue, p. 18). These rules stipulate that Chinese law must be used in agreements under which foreign individuals, companies, or other entities acquire equity interests in domestic companies within the jurisdiction of the PRC. Hence, foreign financial institutions should have a good understanding of the new rules when buying into domestic FMCs.

Through Judicial Auction

As stated above, if FMC shareholders are unable to discharge debts on time, the court will have the right to dispose of equity interests in the FMCs held by such shareholders to a third party via judicial auction. During the judicial auction process, the bidder with the highest price will secure the equity interests, and the successful bidder will then be required to sign an auction confirmation letter with the auction companies under which the successful bidder is confirmed to have secured the equity interests via the judicial auction. At the same time, the court will issue an award to confirm the transfer of the equity to the winning bidder and will assist the successful bidder to complete all the necessary equity transfer procedures.

The advantage of this method is the efficiency of the entire process, due to the court's involvement. The disadvantages are:

(i)  it is time consuming – the whole judicial auction takes approximately 30 days, during which the bidder cannot obtain information on the auction; and

(ii)  due diligence on the equity/FMC cannot be completed within such a short period of time; and

(iii)  the bidder is unable to communicate with management of the FMC regarding the management of the new FMC post-acquisition.

Hence, this method is suitable for foreign institutions which have held detailed talks and have reached agreement with the FMC on key post-acquisition issues. Under these circumstances, the acquirer is not required to negotiate with the vendor or to sign an equity transfer agreement and complete other relevant procedures.

Through Asset and Equity Exchange

Domestic shareholders of a large number of FMCs are state-owned enterprises (SOEs), and thus the FMC equities owned by such shareholders are regarded as state-owned equity. The transfer of such equity is undertaken at the Asset and Equity Exchange across China and is subject to the following equity exchange procedure.

If the SOE shareholders wish to transfer or sell their equity holdings, they are required to apply for an equity transfer and undertake certain procedures at The Asset and Equity Exchange. SOE shareholders are required to announce the minimum sale price for the equity. During the announcement period (usually 20 working days), any acquiring foreign institutions can obtain such equity by accepting the equity selling price. However, if two or more acquirers accept this price, the Asset and Equity Exchange will organize an auction where the party offering the highest price will obtain the equity.

In practice, a number of foreign institutions have obtained the equity of domestic FMCs under this method. Advantages and disadvantages of this method are similar to those of the judicial auction method.

In general, most if not all foreign institutions wish to obtain 49% (the maximum percentage currently allowed under PRC law) of the equity of FMCs through equity acquisition. However, the equity is generally held by a number of shareholders, and so two or all of these methods may need to be employed by the acquirer at the same time in order to acquire the amount of equity desired.