Managing the auction process

If you have already negotiated a deal with an SOE seller, you will want to make sure the PRE process will be conducted in a way maximising your chance to win the bid and, ideally, under the terms and conditions closely reflecting the commercial negotiations. However, this is not always easy - the bidding process can generate surprises or bring in potential competing buyers if not managed well. Thus, a friendly buyer needs to work closely with the seller (who in turn will communicate to the PRE) to carefully structure the bidding conditions (including qualification requirements for potential bidders) which are permissible under applicable rules and local practice, and yet can minimise the number of qualified bidders. When doing so, you should note that PRC law prohibits “obvious identification” of the desired buyer as the only possible bidder, as this will run against the policy goal: solicit multiple buyers to achieve maximum price for state-owned assets.

Specifically, PRC law allows a seller to impose capitalisation, management skill and other qualification requirements for potential bidders. A seller may also specify requirements in relation to price, payment schedule, job retention, debt settlement, etc. Friendly buyers should make good use of these rules and work with the seller to prescribe requirements which are “objective” but also capable of narrowing the pool of potential competing bidders.

In one recent case, a foreign buyer wanted to protect a friendly deal. It believed that there were two main categories of potential bidders: international industry leaders and domestic private equity funds. Given the tight schedule under the PRE rules, for any serious international companies, bidding for a Chinese target without sufficient opportunity to conduct due diligence seemed very unlikely, so the foreign buyer's strategy focused on how to preserve the deal from the domestic private equity investors. The friendly seller finally came up with conditions requiring bidders to have a) five years experience in production and sales; b) an annual turnover threshold for the past three years; and c) own brand and end customers (to exclude original equipment manufacturers). In addition, the seller also required retention of 90% of employees and the keeping of major assets in the current location for a specified period post-closing (to avoid a quick re-sale by a financial investor). As a result, the foreign buyer quickly emerged as the only bidder from the process despite strong interests from a number of potential competing buyers.

For a friendly buyer, it is crucial to work closely with the seller, which in turn maintains constant communication with the PRE. For one thing, the PRE has substantial discretion, within applicable legal requirements, to determine whether the conditions proposed by the seller are acceptable and not overly in favour of any particular buyer. Also, when competing bids are submitted, the PRE has discretion to determine whether sufficient evidence has been shown to establish qualifications for competing bidders.

Breaking a friendly deal

While a friendly buyer could work with the seller to protect the deal, its success is not guaranteed, particularly when the potential competing buyer is well-prepared, and the target company or the seller is not 100% aligned with the intended buyer. In another case, the local State-Owned Assets Supervision and Administration Council (Sasac) wanted to dispose of its equity interest in a Sino-foreign joint venture (JV). The JV's foreign shareholder held a right of first refusal in relation to the sale and brought in another company as its partner to acquire the equity offered by the seller. This friendly buyer was generally acceptable to the seller which had contracted out to this potential buyer some of its management functions. So it appeared to be a lock for this buyer when the seller kicked off the auction process.

But this did not prevent another bidder, a same town competitor of the target company, from jumping into the ring. After carefully analysing the listing terms and conditions published by the PRE, it realized that the seller was, intentionally or unintentionally, leaving some narrow opening for competing buyers because the qualification requirements were not strict enough to exclude a limited number of industrial players, including this new bidder. As a general rule, local governments and Sasac normally have two objectives when listing a large SOE for sale: one is to sell for a good price, and the other is to bring in a high-profile player to their city or province. In this case, the competitor was a well-known international brand and was willing to pay some premium over the listing price. It was granted very limited due diligence after paying the deposit (see discussion below), but eventually won the bid over the initially preferred buyer, who apparently had failed to adopt a strategy sufficiently reinforced to fend off a fellow industry competitor.

Deposit and payment

No buyer would want to pay any money before closing, but this appears to be impossible as PREs normally require a deposit (ranging from 10% to 30% of the listing price in different locations) before allowing a potential buyer to participate in the bidding. On top of this, PREs also charge a commission on the bidder and seller (calculated in various ways as either a percentage of the listing price or the transaction price). To minimise the risks arising from these payment obligations, a buyer must fully utilise all possible flexibilities in applicable rules and devise a realistic and practical strategy on the basis of the relative bargaining power of itself, the seller and the PRE.

In addition to representing a substantial amount of money, a deposit imposes a pre-signing payment obligation on a potential buyer, which is undesirable under any circumstances. At a starting point, a buyer, especially one with strong bargaining power, should try to push it back as there is no clear legal requirement for a deposit, at least at the national level. In theory, the seller has the right to require a deposit, as this is designed to protect the seller if a bidder walks away without a good reason. For the same reason, the seller should be able to waive this requirement. While it is extremely difficult to obtain a waiver, a sophisticated buyer should at least try to negotiate a lower amount.

Where the buyer is an offshore entity, it needs to obtain approval from the State Administration of Foreign Exchange (Safe) to remit funds to the PRE to pay a deposit. This procedure can be lengthy and complicated. One way to avoid this is to offer a bank guarantee to the PRE, covering the same amount of the deposit. If the buyer has strong bargaining position, it may also be able to negotiate some restrictions in favour of the buyer. In one extreme case, a buyer was successful in setting out conditions to the extent that no money could be drawn down without the buyer's prior written approval.

With respect to the PRE commission, a buyer should closely align with the seller to negotiate the amount and, more importantly, to postpone the payment until closing, by way of contracts with the PRE.

Use of PRE form contracts

In regards to deal documentation, a foreign buyer needs to synchronise the terms of the form documents used or imposed by the PRE and those of the actual sales and purchase agreement (SPA) resulting from the commercial negotiation with the seller. The PRE form documents normally include a Purchase Contract, an Engagement Contract between the PRE and the seller, an Engagement Contract between the PRE and the buyer, the Buyer's Application to Accept Bid, etc. All these documents must be filed with the PRE prior to the listing process. From the PRE's perspective, it does not “know” who will emerge as the winning bidder, so the terms of these documents must equally apply to all bidders. Therefore, it is imperative that a friendly buyer that has negotiated detailed terms for the SPA with the seller should carefully review these documents to remove or revise any inconsistencies with the SPA before they are filed with the PRE to become part of the public record.

In particular, the PRE Purchase Contract should be sufficiently broad to allow any “supplemental agreements,” including the SPA. The parties should take necessary measures to ensure there is no conflict between the two contracts, and that the SPA provides detailed provisions for the general principles set out in the Purchase Agreement.

Final thoughts

Acquiring state-owned assets through the PRE listing process presents to a foreign buyer a unique set of challenges deeply rooted in China's peculiar economic, legal and cultural environment. While it is impossible to avoid the impact of the statutory requirement embedded in the process, a sophisticated and well-prepared foreign buyer, with the assistance of experienced counsel, should nevertheless be able to minimise many of the legal and commercial risks associated with this process.

Thomas Man and Xu Liang, Hogan Lovells, Beijing