New regulations concerning venture and private equity investments in China make it more challenging for foreign fund managers and their advisors to assess risk and structure investments in China. Over time, we expect that the regulatory ambiguities will be clarified through the issuance of formal interpretative rules or by more informal means. Until then, foreign VC and PE funds should be prepared to accept heightened regulatory uncertainty in connection with their China investments.
The newly adopted regulations, which became effective on Sept. 8, are called “Provisions on the Mergers and Acquisitions of Domestic Enterprises by Foreign Investors” (the “Revised M&A Provisions”). They replace the “Interim Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors” (the “Interim M&A Provisions”), which were issued in 2003.
This article provides a brief overview of the likely implications of the Revised M&A Provisions on venture and private equity financings in China. However, until China’s Ministry of Commerce (MOFCOM) provides clear implementation rules in connection with the Revised M&A Provisions, the full impact of the rules remains to be seen.
The Revised M&A Provisions include the long-anticipated “share exchange” rules, which are designed to allow for the exchange of shares of domestic Chinese companies for shares of offshore companies. For a “share exchange” to be available in an “equity or asset acquisition” under the Revised M&A Provisions, certain conditions must be satisfied, including the following:
• The shares of the off-shore acquirer must be tradable on a recognized overseas securities exchange.
• The trading price of the offshore company shares must be “stable” during the one year period preceding the transaction.
• The shareholders of the PRC domestic company (and, if applicable, the shareholders of the offshore company) must be the legal owners of the shares and the shares must be legally transferable in accordance with applicable law.
• The shares of both the offshore company and the onshore company must be unencumbered.
Foreign VC and PE funds should be prepared to accept heightened regulatory uncertainty in connection with their China investments.”
Rocky Lee, Partner, DLA Piper
In addition to allowing share exchanges under the foregoing circumstances, the Revised M&A Provisions also provide a mechanism for share exchanges with offshore special purpose vehicles (SPVs) where the SPV will become listed on an offshore stock exchange within one year.
The Revised M&A Provisions are not clear on whether a share exchange will be available in the context of offshore restructurings that do not involve a stock exchange listing. To the extent the Revised M&A Provisions do not allow share exchanges in that context, they represent a disappointment to foreign venture finance and private equity investors. Such investors often restructure their onshore portfolio companies using offshore holding companies, which can be a cumbersome process under existing regulations that do not contemplate share exchanges.
A new regulatory layer
The Revised M&A Provisions, like the Interim M&A Provisions, require regulatory approvals for cross-border M&A activities by foreign investors, including the acquisition by foreign investors of the equity or assets of a domestic Chinese company. In addition, the Revised M&A Provisions create new layers of regulatory approvals affecting offshore SPVs that may impact the ability of foreign investors and their Chinese counterparts to structure in-bound venture and private equity investments.
If a prospective transaction involving cash or equity consideration (or both) qualifies as an equity acquisition or an asset acquisition under the Revised M&A Provisions, the parties must obtain the approval of MOFCOM prior to consummating any of the following:
• Establishing an offshore holding company (if established by a domestic Chinese company or Chinese natural persons).
• The acquisition of any shares of the offshore entity by the shareholders of a domestic Chinese company by way of a share exchange.
• Establishing an offshore SPV directly or indirectly controlled by a domestic Chinese company or Chinese natural person for the purpose of an overseas listing.
In other words, if an offshore entity is established by a Chinese party in connection with an acquisition transaction, and the shareholders of a domestic Chinese company receive shares in the offshore entity as part of such transaction, then MOFCOM approval will be required for both the formation of the offshore entity and the issuance of its shares to the Chinese parties.
Over time, we expect that the regulatory ambiguities will be clarified through the issuance of formal interpretative rules or by more informal means.”
Rocky Lee, Partner, DLA Piper
In addition to the foregoing approval requirements, MOFCOM review will also be required if a foreign party acquires a domestic Chinese company in a “key industry,” or where the acquisition may influence “national economic security” or result in the transfer of a famous trademark or “time honoured brand.” The terms “key industry,” “national economic security” and “time honoured brand” are left undefined and thus subject to MOFCOM interpretation.
Based on these provisions, MOFCOM approval will now be required for the vast majority of private equity and venture financings involving offshore restructurings. The Revised M&A Provisions are sufficiently vague in many respects, leaving ample administrative discretion to MOFCOM. Furthermore, if an M&A transaction is completed without the required MOFCOM review and approval, the Revised M&A Provisions authorize MOFCOM to either rescind the M&A transaction or retroactively amend the agreed contractual terms and conditions of the M&A transaction.
The Revised M&A Provisions set out detailed approval requirements for acquisitions and for share exchanges. Once the application documents have been submitted, MOFCOM will review the application and render a decision within 30 days. If approved, MOFCOM will issue a “Certificate of Approval” for the transaction that is effective for a period of up to eight months. The Revised M&A Provisions also require applicants using an offshore SPV to file an overseas investment registration form with the local department of SAFE.¹
The Revised M&A Provisions require MOFCOM approval if a venture or private equity financing involves the establishment of an SPV by a domestic Chinese company for listing purposes. If the restructuring is effected through a share exchange, the SPV is required to complete its listing on an overseas exchange within one year of its establishment; otherwise the approval will be revoked and the prior shareholding structure restored. Unfortunately, no guidance is provided in the text of the Revised M&A Provisions with respect to the establishment of an SPV if there is no intent by the parties to list within the one-year time frame, as is the case with most offshore holding company reorganizations in China.
We understand that MOFCOM intends to require approval in connection with the establishment of an SPV by a domestic Chinese company, regardless of the intent to list. However, based on discussions with MOFCOM officials on a no-names basis, MOFCOM approval will not be required if the SPV is established by a PRC individual or individuals. Since most venture financings involve the establishment of an offshore SPV by the individual founders of the domestic Chinese company, we do not expect the provisions concerning the establishment of an SPV to impact the majority of venture or private equity financings.
For venture financing structures in which the offshore entity does not directly invest in the domestic Chinese company, but instead forms a WFOE which then enters into a series of captive company contracts with the domestic Chinese company (also known as “Sina contracts”), the analysis under the Revised M&A Provisions is even less straight forward. The Revised M&A Provisions do not directly address a transaction where there is no “direct” acquisition of the shares or assets of a domestic Chinese company. However, we understand that MOFCOM intends to view this kind of structure as an acquisition for purposes of the Revised M&A Provisions, and thus will require that approval be obtained prior to establishing the SPV.
We except that the effects of the Revised M&A Provisions on cross-border mergers and acquisitions, including venture capital and private equity financing deals, will become clearer during the remainder of the year, either through the issuance of formal interpretative rules by MOFCOM or through more informal discussions with MOFCOM in connection with ongoing and future M&A and financing transactions.
Rocky Lee is a Partner with DLA Piper and head of the firm’s Venture Capital & Private Equity Practice in China.His clients include Sequoia Capital China, Kleiner Perkins Caufield & Byers, TDF Capital, Granite Global Ventures, Qi Ming Venture Partners and Intel Capital. He is based in the firm’s Beijing office and may be reached at Rocky.Lee@DLApiper.com. Partner Matt Adler and Senior Associate Christopher Terry contributed to this article.Footnote (1): SAFE promulgated Circular Notice No. 75 (Notice of the State Administration of Foreign Exchange on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents to Engage in Financing and in Return Investments via Overseas Special Purpose Companies) (“Circular 75”) on Nov. 1, 2005. Circular 75 establishes a registration requirement for PRC residents who make “round-trip investments,” that is, investments in offshore holding companies that own PRC businesses.