Key challenges of acquisitions by foreign investors in China
February 2014 | PROFESSIONAL INSIGHT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
As we embark on the new year, it seems a good time to revisit some of the transactions that took place over recent years and share with foreign investors insights into some of the key challenges and pitfalls they will encounter when acquiring a Chinese company, which usually make the acquisition process difficult, time-consuming and costly.
As an overview, the legal regime governing cross-border acquisitions in China remains complicated and restrictive, notwithstanding years of evolution. Foreign investors have to overcome the restrictions under The Regulations on Merger with or Acquisition of Chinese Domestic Companies by Foreign Investors (as amended and restated in 2009, the ‘M&A Rules’), the primary legislation governing acquisitions of Chinese companies by foreign investors, and will likely face other challenges such as merger control filing and national security review.
Generally, the acquisition of Chinese companies by foreign investors is subject to the M&A Rules, which requires, among other things, that: (i) the acquisition must be approved by the local counterpart of the Ministry of Commerce (MOFCOM) at the state or provincial level; (ii) the purchase price must be determined based on the valuation of the target by a Chinese appraisal firm; (iii) the form of consideration is limited to cash only (i.e., the seller cannot be paid in the form of buyer’s stock or other equity interest); (iv) the payment must be paid within three months after the closing (or a maximum of one year in special cases); and (v) as a matter of practice, the purchase price has to be a fixed amount, and price adjustment or earn-out is not feasible due to foreign exchange control.
Merger control filing
Under the PRC Anti-Monopoly Law (AML) enacted in 2008, where the acquisition triggers a change of control and the combined and respective global or Chinese turnovers of the parties exceed certain filing thresholds (which are relatively low), the deal must be filed with MOFCOM and the completion of the transaction must be conditioned upon clearance from MOFCOM (with or without remedy). A typical merger control filing process will take five to eight months, including the time required for: (i) preparing the filing report; (ii) pre-review before official acceptance by MOFCOM; and (iii) MOFCOM’s official review process. It is worth noting that only step (iii) is subject to a salutatory time limit provided under the AML, and in practice it may take longer than expected to collect the comprehensive information to come up with a report acceptable to MOFCOM. The good news is that a draft regulation on a simplified procedure for simple case review has been circulated for comments, and the official regulation is anticipated to be released within the next few months.
National security review
Since early 2011, the acquisition of Chinese companies by foreign investors is subject to a national security review (NSR), if the industry of the target is military-related or involves potential national security concerns such as significant agricultural products, significant energy or natural resources, significant infrastructure and transportation services, key technologies and the manufacturing of material equipment. There is no clear-cut definition or clarification of the terms ‘significant’, ‘key technology’ and ‘sensitive’, and there is no published list of specific industries which are covered in the scope of an NSR. In practice, the government retains significant discretion as to whether an NSR is required for a particular transaction. If the target’s industry falls within a grey area and the parties decide not to undergo the review, there is always a risk that the deal may not be closed, or if closed, may be required to unwind. The enforcement of NSR is still at an early stage, thus the timeline is difficult to manage, the process is not fully transparent, and the number of precedents remains very limited.
Every transaction starts from due diligence, which does not usually go smoothly in M&A transactions in China.
Limitations of due diligence
Disclosure by a Chinese seller is often limited, especially where the target does not have a centralised file keeping system and has to collect documents from various locations and departments. False disclosure and document forgery can also be an issue when dealing with some PRC entities (particularly privately owned companies). It therefore requires more experienced attorneys to be involved to review the documents (at least material documents) and to verify the information by various means such as management interview, government visit and independent investigation. The resources in China for independent investigation are very limited. Apart from searches for corporate documents filed with the administration of industry and commerce (i.e., the company registrar), searches on the websites of the China Trademark Bureau and the China Patent Bureau, searches of real properties titles and searches of very limited litigation information, there are no publicly available means to verify the information provided by sellers.
Expanded scope of due diligence
In the past, compliance due diligence was omitted or inadequate due to cost concerns and the practical difficulties of conducting an in-depth investigation. Since compliance issues (including anti-bribery issues and AML violations in terms of monopoly agreements and abuse of dominant market position) came into the spotlight and a number of investigations were brought by the Chinese government in 2013 (followed by the imposition of significant penalties), it seems more sensible than ever to conduct an in-depth compliance due diligence in an acquisition, despite the practical difficulties and additional cost. Similarly, we see more and more IP infringement cases with a significant amount of damages claimed. We also see environmental issues being prioritised by the government and causing serious concern to the general public. Foreign investors should consider an expanded and in-depth due diligence to cover such areas, which requires special expertise and is usually handled by expert counsel.
It is not surprising when an unsophisticated international buyer fails to implement its acquisition in China as quickly as a comparable transaction in its home country.
One of the most critical challenges when acquiring in China is to manage the timeline. Many Chinese sellers and targets are not sophisticated when it comes to completing an acquisition. It may take a few months to negotiate an international standard purchase agreement in dual languages, and several more months to obtain regulatory clearance. We hear complaints that international buyers may have to ‘educate’ a Chinese seller before they can talk on the same page, and Chinese regulatory clearance becomes the gating factor on some global deals and in such casesthe parties had to close the China part of the transaction separatelyafter closing the global deal.
Generally, MOFCOM’s local counterparts (in particular, those located in undeveloped areas) may have limited exposure to cross-border acquisitions. Where the provincial government delegates the authority to a lower level government, officials of the lower level government who have not seen a sufficient amount of transactions may be inclined to act conservatively and hesitant to approve a purchase agreement on unfamiliar terms.
Acquisition by its nature is a high risk business activity, and becomes more challenging for foreign investors that do not have much experience in China. Foreign investors should envisage the challenges and pitfalls of acquisitions in China in advance, and address the issues proactively. Ambitious investors who rely too much on their intuition and experience in other jurisdictions are often frustrated by the unique business and regulatory environment in China and find it onerous to sign and close a transaction. We recommend that foreign investors do their homework with patience and caution before making the decision, and engage experts with appropriate local experience and expertise to provide practical advice and guidance.
Daniel He is a partner at Jun He Law Offices. He can be contacted on +86 21 2208 6288 or by email: firstname.lastname@example.org. The author would like to thank Yu Cui, an associate at Jun He Law Offices, for his assistance in the preparation of this article.
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Jun He Law Offices