Tengzhong loses Hummer

A month after the first announcement, Lee Edwards, China managing partner of Shearman & Sterling (which acted as international legal counsel to Tengzhong), confirmed reports that the Ministry of Commerce (Mofcom) had not yet received a formal application regarding the Hummer deal.

“With respect to Mofcom no formal application has been made – definitive documentation has to be agreed first,” he told CLP.

By the autumn, it seemed new hope had emerged. On October 9, it was reported that GM had completed the agreement with Tengzhong, and three days later Reuters reported that the Chinese company was still talking to the regulators and hoped to close the deal by the end of the year or early in 2010.

But after many rumours, leaks and unattributed comments from “sources close to the regulators”, it was finally announced on February 23 this year that Tengzhong had withdrawn its offer for Hummer. Although the reasons were not made public, and despite denials from Chinese government officials, many commentators have speculated that the buyer was unable to secure the necessary regulatory approvals.

So what went wrong? Apart from the obvious mismatch of the Hummer brand with the Chinese government's push for clean, green technology, most commentators say the buyer simply did not have the expertise to sustain the deal; another aspect may have been the price. Clearly, other companies do not want to suffer the same fate as Tengzhong and Hummer, and will be eager not to commit to a deal without some assurances that it is more than likely to go through.

“It's best to take the common sense approach of talking to the regulators about these things before you get too far down the line. If you're doing something that is regulated, common sense says that you go and talk to the regulators at a very early stage,” says Fred Kinmonth, a Hong Kong-based partner of Minter Ellison.

It seems Tengzhong was indeed taking this common sense approach. Last year Edwards acknowledged the importance of frequent discussions with the Chinese authorities through which the regulators could gain an opportunity to become familiar with the transaction. This would lead to a reduction of the time required for formal post-filing review and give the parties a chance to identify any concerns in advance of signing the definitive transaction documents. Perhaps some deals are simply not meant to be.

An offshore approach?
Almost immediately after the announcement, some outlets began to report that GM and Tengzhong were exploring alternatives; a Wall Street Journal blog post said both parties were “considering setting up an offshore company to continue to pursue the deal” and added that the China Business News had reported the sale of the “New J&A Hummer Fund” by a Shenzhen-based private equity firm. But specialists say this approach is not viable.

“The idea of getting round the regulators by doing it offshore is somewhat naïve,” says Kinmonth.

“There's nothing simple about setting up an offshore structure to do the acquisition,” adds Elizabeth Cole, a corporate partner in Orrick Herrington & Sutcliffe's Shanghai office.

An offshore investment made by a Chinese entity would still require approval from both Mofcom and the NDRC. The second of these regulators – which examines the overall commercial aspects of an outbound deal – must approve any Chinese company's purchase which exceeds US$10 million, even if it is made through an existing offshore structure. Mofcom, meanwhile, examines the international aspects of outbound deals from a legal perspective, although a new investment made by an existing offshore subsidiary simply needs notification after the transaction has closed.

One apparent means of circumventing such requirements (and perhaps the sort of structure alluded to by the Wall Street Journal and other commentators) would be to set up the deal so that it did not involve an acquisition of the actual business or its assets – using the combination of a licence agreement, employment agreement and production contract agreement, for example.

“The problem here is that the investor is onshore and has to kowtow to the Chinese government even though it's a private company,” Kinmonth says.

There is another fundamental issue here – how the purchasing entity will finance its acquisition.

“At some point you're going to have to get government approval – you need to go through the State Administration of Foreign Exchange [Safe] and get the remittance approved,” says Cole. Unfortunately, at this point the company would run into a paradox – remittance approval for conversion of renminbi to foreign exchange funds will not be granted without prior approval of the foreign investment or some other approved purpose. This means the only way a company such as Tengzhong could hope to avoid immediate regulatory intervention would be to use an offshore entity which was already funded, or structure the transaction in some other way that did not require any remittance of funds out of China.

“It could conceivably work through that entity and do the acquisition through that entity assuming there are no forex issues,” says Cole.

Tax is another important consideration, particularly taking into account recent regulations which mark an increased scrutiny by the Chinese tax authorities of sales of interests offshore.

“So they may get caught down the track – even if they don't get caught now,” Cole says.

Last year, there was a flurry of legislative activity covering outbound investment, with the issuance of Mofcom's Measures for the Administration of Outbound Investment (境外投资管理办法) on March 16 2009, the NDRC's Circular on Relevant Issues Concerning Improving the Administration of Outbound Investment Projects on June 8, and Safe's Provisions on Foreign Exchange Control in Connection with Overseas Direct Investment by Organisations in China (境内机构境外直接投资外汇管理规定) on July 13. But despite the abundance of black-letter law, the relevant rules remain vague in places, adding to the woes of companies who are attempting to use novel acquisition structures. For example, although regulations refer to the acquisition of “other interests” (apart from the actual assets) being reviewable by the authorities, there is doubt over the precise meaning of this expression.

“If you are taking on all the risks and rewards of the operation, even though you haven't acquired ownership of any assets, you may have effectively acquired the business,” says Greg Liu, a Paul Weiss Rifkind Wharton & Garrison corporate partner based in Beijing.

Tengzhong was dealing in an industry which does not involve a great deal of registered IP, which may have reduced the risks of it appearing to acquire actual ownership of the Hummer business. But the deal involved manufacturing at its core, and in any manufacturing deal it would make commercial sense eventually to transfer some or all of the production to China – triggering regulatory intervention. After previously turning down an application, it would be extremely unlikely that the regulators would later give their approval to parties which had deliberately tried to avoid their oversight.

The moral of the story
As well as abiding by applicable laws and regulations, companies operating in China must be acutely aware of any policy considerations at play. Although the government is, at the moment, promoting outbound investment, it is also keen to ensure investments are correctly targeted, and that they fit in with other high-level policies – on environmental protection and enhancement of local IP for example. Despite what the regulations may say, such considerations could easily take priority.

“Even if no approvals were required in China, for a deal of this high-profile nature, if the government called the buyer and said 'Don't do it,' then they wouldn't do it,” says Kinmonth.

Cole suggests companies involved in a Chinese outbound investment which may come under the scrutiny of the NDRC should ask themselves an important question: Am I doing a transaction that is a straightforward, normal commercial transaction, or something that is quite high-profile?

A company in an industry that is encouraged under current government policy, particularly if it is making a small investment below the US$10 million threshold, should find it quite simple to do the necessary filings.

“[But] if it's high-profile, you need to work harder with a strategy that takes into account not only the regulations but any public image impact that may conflict with Chinese policy,” Cole says.