A new year for China M&A

“2009 will be the year of acquisition finance in China,” says Paul Hastings Janofsky & Walker in one of its recent newsletters. Regulators have now put in place most of the necessary foundation for such financing.

    Near the end of 2008, the State Council announced its intention to promote economic development and maintain domestic stability when it issued its Nine Measures. To support those measures, the Guidelines on Risk Management of Acquisition Loans of Commercial Banks (商业银行并购贷款风险管理指引) were issued by the China Banking Regulatory Commission (CBRC) on December 6 2008. They allow “strong” commercial banks to loan money to companies (or their subsidiaries) for the purpose of paying M&A transaction fees, and were described as “groundbreaking” by one PRC lawyer at the time.

    The rules provide clear guidance and restrictions on exposures, leverage ratio and tenor of acquisition loans. They do not include any licensing requirement on bank establishments, a sign that the government wants more banks to enter the market.

    A few weeks after the rules were issued, the Shanghai branch of ICBC and the Bank of Shanghai finalised an agreement with the Shanghai United Assets and Equity Exchange under which they can use the Exchange as a platform to extend their acquisition finance capability. The banks agreed to offer a total of Rmb10 billion (US$1.46 billion) for M&A transactions.

    Acquisition financing was previously prohibited by Article 20(3) of the 1996 Lending General Provisions which were issued by the People's Bank of China (PBOC). This put specific restrictions on a lender, stating: “Except where otherwise stipulated by the State, a borrower may not use the loan to engage in equity investments”.

    Although it appears that the CBRC's new Guidelines should overturn the old rules, at least one lawyer has doubts over the legality of lending for M&A.

    In 1996, the PBOC was China's only banking regulator; it now ranks equally with the CBRC. But rules and regulations such as the Lending General Provisions carry more weight than guidelines.

    “Unless PBOC lifts this restriction or otherwise resolves the inconsistency, banks may be reluctant to extend credit for acquisitions,” says Maurice Hoo of Paul Hastings. “I understand that even among the banking regulators it has been widely discussed that the PBOC rules should be amended to resolve this conflict.”

    Hoo also reports that compliance officers of some foreign-owned banks have expressed concerns over the legal weight issue; these have been partially allayed by confirmation from the CBRC that any plan for an acquisition financing product must receive its approval. The risk of being challenged by the banking regulators is therefore small. But the fact that most foreign-owned institutions have been slow off the mark to develop new products may reflect differing levels of concern over an ambiguous technical point.

    “Market practice does not resolve the legal ambiguity,” says Hoo.

    If and when this ambiguity is resolved, it is not expected that there will be a flurry of acquisition financing activity.

    “The rules are still very general and not clear in certain respects. They mainly encourage industrial investors rather than financial investors,” says David Liu, senior partner of Jun He Law Offices in Shanghai.

Make currency conversion easier

The credit crunch has turned the world on its head, and China must take quick, practical steps to help business cope. This is the view of DLA Piper partner Ghislain De Mareuil, who advocates a simple but drastic step to make acquisitions by FIEs easier.

    On August 29 2008, the State Administration of Foreign Exchange (Safe) issued Circular 142 (the Notice of the General Affairs Department of the State Administration of Foreign Exchange on the Relevant Operating Issues concerning the Improvement of the Administration of Payment and Settlement of Foreign Currency Capital of Foreign-funded Enterprises). This circular aimed to slow the flow of hot money into real estate, and tightens the administration of inflows of foreign exchange by making it tougher for FIEs to convert paid-up capital into renminbi. FIEs cannot use converted renminbi to make an equity investment in a domestic company, unless the investment is within the “approved business scope” of the FIE.

    The Circular also has a significant impact on M&A. Although several sources have reported that Safe has verbally confirmed it did not intend the Circular to stop asset investment using converted renminbi, FIEs wishing to do so will need to use more complex investment structures.

    The FIE must first set up an exclusive foreign currency account, approved by the local Safe branch. This account must be used to settle the purchase consideration – the FIE cannot simply convert the foreign-currency consideration into renminbi to settle the purchase.

    “Safe should repeal Circular 142. It's very easy – they don't have to redraft the whole regulatory landscape – it's not a grand scheme,” De Mareuil says.

    “Circular 142 is completely outdated today; when it was issued it was another world,” he continues.

    When Safe put the system in place, one of the government's priorities was to fight price increases in the real estate market. Now it is promoting investment in real estate, but this kind of investment, as well as M&A deals, is inhibited by the Circular, argues De Mareuil. He tells the story of one deal which had been approved by all the appropriate Chinese authorities. When it came to settling the purchase by converting US dollars into renminbi, the transaction hit problems.

    “We had to convert a small amount each month. The client was supposed to pay in two months, but it took six months.”

    Hoo says that the Circular was simply designed to make sure that investments were being done properly, and it is unlikely that it will be repealed.

    “I don't expect this to go away – it tells banks to check what money is for. The government is telling companies to invest through the proper channels.”

    Although China is taking some decisive steps to counter its potential economic problems, it will continue to take a measured approach, says Hoo.

    “Repealing 142 is pretty radical,” adds Donald Hess, M&A partner of Jones Day in Hong Kong. “It's a policy concern for government. As long as the policy [of regulating foreign exchange] remains, the obvious way [to implement it] is through a Circular such as 142.”

    Despite this debate, lawyers agree that several ambiguities and the generally broad drafting of the Circular will make life more difficult for FIEs as the rules may be applied inconsistently by local Safe bureaus.

    “It's one step backward toward uncertainty,” says De Mareuil.

Allow contingency consideration for non-public deals

Non-public deals – those involving private equity and venture capital – are likely to come to the forefront in China in the year ahead. Recent figures show that public listings have almost completely stopped, while private equity capital under management in China grew by 85% in 2008 (the figure for Asia-Pacific as a whole was only 14.4%).

    For non-public deals, the ability to structure a “contingency consideration for an acquisition” would be very useful, and very popular with investors, says Hess, as it would give foreign investors more flexibility to manage their deals. It is already a common practice in the US, where an investment may often be made subject to conditions: a post-completion audit and potential price adjustment, for example.

    “It's difficult to structure this in China,” says Hess. “The Ministry of Commerce won't usually approve deals if they are subject to any conditionality.”

    Although it would require a change in administrative practice, according to Hess there is nothing in Chinese law which says these structures are impossible.

More clarity, more clarity

It is often said that the biggest worry for any investor is uncertainty. This means there is plenty for investors to worry about in China. Whichever words are used to express it – whether “clarity”, “transparency”, “simplicity” or “less ambiguity” – it is obvious that this is one of the top concerns for practitioners in China.

    Many fairly common transactions still require explicit approval from government agencies. Hess cites the example of a 50/50 joint-venture that needs more money.

    “In Hong Kong or the US, one party could lend money to the venture. In China, you typically reach a brick wall even if the amount required is within the approved investment amount,” he says.

    The parties will find it very difficult to put in place the loan and security arrangements which are typically needed to give comfort to the lending shareholder, and it is the regulatory framework which often creates the barrier. In such a situation, the foreign investor will sometimes seek to take security over the local party's equity, and enforcement of this security needs approval from the Ministry of Commerce (Mofcom).

    “Enforcement depends on Mofcom's approval, and foreign investors typically get nervous over this because of the lack of certainty,” Hess says, adding that many investors would find it helpful if the Ministry would issue explanatory guidelines.

    Roger Denny, head of Asian M&A at Clifford Chance, says that China needs to continue to focus on the clarity of decision-making in regard to approvals. The general lack of clarity is affecting the attitude of investors at board-level globally, he says.

    “One of the major concerns is the transparency of the process and how fairly the rules will be applied.”

    Like many of his peers, Denny welcomes the recent steps taken by Mofcom when it published draft guidelines for the Anti-monopoly Law for public comment.

My wish is for more wishes

A wish list for M&A reform in China has the potential to be almost unlimited. Many private practitioners and in-house counsel are calling for more guidance on the PRC Enterprise Income Tax Law (中华人民共和国企业所得税法) (which became effective on January 1 2008; Implementing Regulations took force two months later) and the Asset Appraisal Law, and a more relaxed background for cross-border deals which are regulated by the 2006 Provisions on Acquisition of Domestic Enterprises by Foreign Investors (关于外国投资者并购境内企业的规定). But for many, the primary concern is over the Anti-monopoly Law.

    January 2009 saw seven draft documents and a flowchart published on Mofcom's website, leading to a flurry of updates and client alerts from law firms in the region (full translations of some of these documents can be found on pages 75 to 84).

    The documents have cleared up several important issues including procedures for the notification of concentrations, pre-filing consultation, definition of the relevant market, the right way to calculate turnover, and how to determine when one party has acquired control of another. But not everything has been dealt with yet. Among other things, there are ambiguities over the amount of internal information which companies need to hand over to Mofcom, as well as continuing confusion over filing deadlines.