Going global

China Law & Practice's Annual Review was released at the Awards Ceremony in Beijing this month. Part of the Annual Review comprises insights from leading lawyers. In this Q&A, Zhang Ying discusses the busy M&A market and how policy developments are changing the way deals are structured.

1. What were the key legislative developments affecting M&A in the past year?

A number of important regulations in the M&A sector were issued in 2011 and are summarised below.

Security review system

After the General Office of the State Council issued the Circular on the Establishment of a System for Security Review of Acquisition of Domestic Enterprises by Foreign Investors on February 3 2011, the Ministry of Commerce formally released the Provisions for the Implementation of the System for Security Review of Acquisition of Domestic Enterprises by Foreign Investors on August 25 2011. This takes preliminary steps to establish a system whereby a security review must be passed for acquisitions by foreign investors in certain industries and sectors, such as military armament and national defence enterprises, enterprises in sensitive military facilities, important agricultural products, energy, infrastructure, transport services, technology, equipment manufacturing and other industries where actual control may be secured by the foreign investors.

The implementation of the security review system adds a separate review from the government examination system and approval of acquisitions by foreign investors. However, as it does not provide clear sub-categorisations of industries and sectors, it lacks detailed provisions on how to determine the circumstances in which control may be secured by the foreign investors. This makes the scope of the security review vague and causes problems in practice. One way to reduce uncertainty is to prepare fully and conduct informal talks and liaise with the authorities before formally applying for a state security review.

Furthermore, the Provisions also clearly bring “holding on behalf of another, trusts, multi-level reinvestment, leases, loans, control by agreement, offshore transactions” or other means within the scope of the security review of acquisitions, thereby increasing the legal risks of effecting acquisitions through VIEs for example, that is, carrying out investments through a series of agreement arrangements, rather than equity arrangements, and ultimately achieving consolidated accounting statements.

Revisions to the industrial catalogue

The National Development and Reform Commission and the Ministry of Commerce promulgated the revised Foreign Investment Industrial Guidance Catalogue at the end of 2011, making high-end manufacturing a key sector in which foreign investment is encouraged, promoting foreign investment in the modern service industry, moving foreign-invested medical institutions and financial leasing companies, for example from the restricted category to the permitted category, and further opening up the cultural, sports and leisure industries to foreign investment. However, the revised version also strengthens restrictions on foreign investment in the agricultural by-product processing and distribution sector. These revisions will have a guiding effect on future M&A by foreign investors, possibly leading to a marked increase in foreign investment in sectors encouraged or no longer restricted by the state and for which there is great market potential in China, such as the pharmaceutical sector.

Cross-border direct investment in renminbi

In October 2011, the Ministry of Commerce and the People's Bank of China respectively issued the Circular on Issues Relevant to Cross-border Direct Investment in Renminbi and the Measures for the Administration of Renminbi Settlement Matters Relating to Foreign Direct Investment, permitting offshore investors to engage in direct investment activities in China in accordance with the law using renminbi lawfully obtained offshore. Furthermore, at the beginning of 2011, the People's Bank of China issued the Measures for the Administration of Pilot Projects for the Settlement of Renminbi Directly Invested Overseas, permitting non-financial institutions registered in the pilot areas for the renminbi settlement of cross-border trading to engage in direct investment activities offshore using renminbi funds.

These provisions are an important step in the internationalisation of the renminbi and, in particular, permitting foreign investors to invest lawfully obtained renminbi will satisfy the wishes of many Chinese sellers for foreign investors to make payments in renminbi in M&A transactions and will be conducive to the promotion of cross-border M&A.

2. What is your outlook for M&A for the year ahead? What legislation is likely to affect M&A? What changes would you like to see to already promulgated legislation to ease M&A transactions?

One legal factor affecting inbound M&A is the state security review. The main headache here is the lack of clarity, which gives rise to market hopes for more specific rules. The question of the lawfulness of VIEs remains unresolved, with the market continuing to wait and watch for a new policy direction.

Furthermore, not long after the relevant policy was issued, we assisted a client in attempting a domestic investment with offshore renminbi, for which they smoothly secured approval. The demand for foreign investors to make domestic investments in renminbi is strong. With the maturing of the approval procedure and the accumulation of regulatory experience, the procedure for cross-border direct investment in renminbi in 2012 will be clearer, so it is possible that M&A capital contributions made by foreign investors in renminbi will become a trend.

China has now set in motion the procedures for revising the Employment Contract Law, with focus on regulating the placement of temporary workers. If the amended version tightens up on the issue of the placement of temporary workers, it could increase the manpower costs of enterprises in M&A and could cool the already rather tepid M&A market, particularly M&A projects in labour intensive industries.

3. Which sectors attracted the most outbound M&A investments and why? What are some of the key trends you are seeing in M&A deals?

In outbound M&A by Chinese enterprises, in addition to the traditional resource mining and energy sectors, the food and dairy products, agriculture and other sectors have also become points of interest. This is due to China's huge population and the public's worries about food safety that have pushed the agriculture, food and other industries into becoming China's strategic industries. Few offshore acquisitions by Chinese companies are aimed at securing the local market, as the majority remain in the service of the Chinese domestic market. This means that due to the large differences in the legal and cultural environments, the cross-border acquisition of the US cinema group AMC by Dalian Wanda is a solitary case unlikely to be reproduced in the short term and unlikely to result in a large number of Chinese enterprises investing in cultural and media markets abroad.

4. How do measures promulgated by local governments conflict with national-level legislation? How does this affect deals? How do you overcome these measures?

In legal practice, local governments regularly issue incentive policies to attract foreign investment. Local pilot provisions occur where there is a lack of clear provisions nationally. As this type of incentive or special local policy does not directly conflict with national laws, the risks are low. However, as higher level legislation is silent, there remains uncertainty. For example, places such as Shanghai, Beijing, Tianjin and Chongqing previously issued local pilot provisions for QFLPs (Qualified Foreign Limited Partnerships), permitting qualified foreign investors to participate in the investment and establishment of foreign-invested private equity investment partnerships (funds) in China. Given the vagueness of their provisions on the status of the funds, whether domestically invested or foreign-invested, the market at one point interpreted them as meaning that where foreign exchange capital contributed by an offshore investor was less than 5%, it would not affect the fund's nature as domestically invested, and in a short time a number of new funds were established based on these provisions. However, the National Development and Reform Commission provided clarification in a circular in 2012, stating that a capital contribution made in foreign exchange by an offshore investor does affect the domestically invested nature of a fund, and restricted the incentive policies of the local pilot projects.

Then there are unlawful local incentives granted in violation of state provisions. Examples here include refunding through local finances, reducing land grant prices in a disguised manner or providing tax breaks. As these provisions directly conflict with higher level legislation, the long-term legal risks are high and investors may face the risk of the incentives being unrealisable and being asked by the national government to rectify them.

Finally, there are cases of discrepancy between specific local provisions and implementation, on the one hand, and the requirements of state regulation on the other. For example, with respect to payment for labour insurance and the social insurance fund, a number of local governments have not required enforcement in strict accordance with state regulations. Although actual risks in the short-term may not be great, the risk of pursuit in the future cannot be precluded due to the existence of the legal defects.

With respect to the issue of local incentive policies, the specific circumstances must be looked at and a concrete analysis and assessment made, and legal counsel's grasp of the relevant legislative intent and policy direction is crucial. The parties to a transaction should carefully balance the advantages and disadvantages, and seek an appropriate protection and risk sharing mechanism.

5. It was reported that Chongqing received more FDI than Beijing last year, is this a trend you have seen and what advice do you have for M&A transactions in China's interior cities?

Whether foreign investment is directed to interior cities or to first line cities like Beijing and Shanghai is dependent on factors such as state and local policy incentives, the synergistic development of related industries, production cost considerations and specific business needs. The appeal of interior cities to foreign investors is increasing due to state and local incentive policies for investing in central and western China, low labour costs and inexpensive land prices.

In an M&A project involving an interior city, sufficient and effective liaison with the approval authorities is important. Furthermore, foreign investors should be fully aware of and assess the competitive disadvantages of interior cities in terms of labour quality, urban facilities and the quality of the local judicial systems.

6. If you could offer one piece of advice to foreign clients about to engage in M&A, what would it be?

For a lot of foreign acquirers, many of China's legal requirements in cross-border M&A are unfamiliar. For example, in foreign exchange and tax control related issues, Chinese laws contain statutory provisions on M&A pricing and time limits on payment, generally not permitting the parties to a transaction to freely negotiate such terms, meaning that transaction protection measures and pricing mechanisms commonly used internationally, such as earn-out and holdback, face obstacles and uncertainty under Chinese law. This means that, when handling an M&A project, it is essential to have lawyers with an in-depth understanding of Chinese laws and extensive practice experience to assist both parties to the transaction in assessing the risks and designing an alternative localisation plan so as to reduce Chinese legal risks to the greatest extent possible while still achieving the commercial objectives.

走向国际

君合律师事务所的合伙人张颖对中国交易频繁的并购市场的主要趋势，作出了扼要的阐述，并评估了人民币逐步迈向国际化的影响

1. 去年有哪些影响并购的重要法规出台？

2011年，在并购领域有一系列重要法规出台：