Material asset restructuring (MAR) in Chinese outbound investments
June 2018 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2018 Issue
Outbound investment is a challenging undertaking for any Chinese company. If a Chinese investor is a listed company, and the target business is of a substantive nature compared to the assets and value of the Chinese investor itself, the acquisition is even more challenging. In such a scenario, the intended acquisition could form a material asset restructuring (MAR) event under Chinese statutory provisions. We note an increasing number of cases where a MAR situation occurs in connection with a Chinese outbound investment.
The regulatory requirements for listed Chinese investors in an MAR scenario add an additional layer of complexity to the, already quite complex, outbound acquisition process in which a Chinese investor participates. One of the most challenging situations arises if the target entity is still in the process of being carved-out from the seller or its respective group companies. This article aims to outline the implications of a MAR situation on the M&A process when a Chinese listed investor acquires an offshore target.
A China outbound investment by a listed company, or any company held or controlled by it, may qualify as a MAR situation for several reasons that are predominantly related to the financial impact of the acquisition.
A MAR situation is when, inter alia, the total assets purchased account for 50 percent or more of the listed company’s total assets or if the operating income from the purchased assets in the last fiscal year accounts for 50 percent or more of the operating income, as specified in the listed company’s audited consolidated financial statements for the last fiscal year. A forward-looking approach can also be taken in order to determine a MAR situation, i.e., where the purchase of assets by the listed investor will cause, within 60 months after the closing date of the transaction, ‘fundamental changes’ to the listed company. The competent authority that oversees and handles the MAR procedures is the China Securities Regulatory Commission (CSRC).
The listed Chinese investor is required to provide CSRC with a substantial amount of information in connection with the MAR procedure. Besides documents and information concerning the Chinese investor itself, the seller, the background and purpose of the intended transaction and detailed information on the target to be acquired needs to be submitted – particularly information pertaining to the development of the target’s business in the last three years and audited financial data for the last two years. If the target is still in the process of being carved-out during the transaction, this particular requirement constitutes an imminent practical challenge, since the Chinese investor needs to discuss with the seller how to meet the expectations and requirements of CSRC if the target did not even exist, as a separate entity, during the time frame for which the financial data is required.
Given the complexity of a MAR process, it is necessary to decide at an early stage whether the Chinese investor will be able to finalise the MAR process prior to the closing date, i.e., between signing of the sale and purchase agreement (SPA) and the closing, or only as a post-closing event. In practice, we have seen both alternatives being applied. If a Chinese investor and the seller agree to have the MAR process finalised prior to the closing date, this requires a high degree of planning and process management. A pre-closing MAR process adds an additional layer of activities and work streams for a time period of between six and nine months after the signing of the SPA, which adds to the further challenges of this pre-closing period, such as obtaining merger control clearances or foreign investment approvals and separation from the seller group.
If parties agree that a Chinese investor will finalise the MAR process prior to closing, closing will usually depend on the completion of the MAR process as a condition precedent (CP). In such case, it is of utmost importance for the Chinese investor, prior to signing, to structure the MAR process in a way which meets relevant SPA deadlines (in particular, long-stop dates). The seller will certainly request detailed protection mechanisms and provisions concerning the finalising of the MAR process. Generally, a clear benefit of a MAR process being finalised pre-closing is a rather straightforward acquisition structure on the side of the Chinese investor, given that there is no need to arrange for any mechanism to ‘circumvent’ statutory provisions on MAR.
Such a mechanism could include a structure under which the Chinese investor, i.e., the listed company, would team up with further investors and form a consortium in which the Chinese investor would not hold a controlling stake. Such a consortium structure generally has certain disadvantages, in particular in terms of negotiating time-consuming arrangements between the investors in the consortium. In addition, CRSC has recently become more restrictive in accepting a consortium structure as a ‘way out’ of MAR.
The seller will clearly expect a Chinese investor to consent to a penalty, i.e., payment of a specific break fee, if an agreed long-stop date cannot be met for reasons related to the MAR process. However, finalising a MAR process is highly dependent on the cooperation of the seller. A Chinese investor is therefore well-advised to thoughtfully negotiate a request for a break fee related to MAR. Namely, a Chinese investor may want to clarify with Chinese authorities, and thereafter agree with the seller, the information to be provided by the seller in relation to the transaction, to the target and to the seller itself. However, practice shows us that the level of detail to be provided differs in each transaction and is hence difficult to fully predict.
The amount of a break fee to be paid can be substantive. We have recently seen sellers ask for 10 percent or more of the purchase price as break fee in China outbound investments. Given the competitive environment for Chinese purchasers, a Chinese investor will seldom be able to negotiate a break fee below 5 percent of the purchase price.
In specific circumstances, the information required for MAR becomes increasingly difficult to obtain. If a target entity is in the process of being carved-out from the seller group and the carve-out is only finalised around or after the signing of the SPA, there will be questions as to how the seller can deliver all historic financial data, including audited reports for the preceding two to three financial years. Such audited reports would generally not exist before the carved-out entity has been put in place by the seller, and the seller would have to indicate which documents could be delivered instead – e.g., excerpts of previous financial statements for the entire group of the seller, but limited to the specific business to be acquired by the Chinese investor, pro-forma statements or the like.
Once an inability of a seller to deliver materials and information that meets statutory requirements has been identified, a Chinese investor must enter into discussions with Chinese authorities, namely the relevant stock exchange and the acquisition restructuring commission under CSRC, in order to clarify which other documents and information they would accept instead. Several weeks should be set aside for such discussions, including final clarification with the seller whether, and in what time frame, the requests of the Chinese authorities with regard to the target entity would be met.
If a MAR is not agreed as a CP for closing of the acquisition, a Chinese-listed investor must not act as the sole or controlling purchaser of a target during the acquisition process, since this would violate statutory regulations. In practice, we see arrangements under which the (final) Chinese investor enters into a consortium agreement under which the other members of the consortium will have the controlling power until MAR procedures are finalised. With respect to a Chinese investor, this obviously adds a layer of complexity to the acquisition – meaning it will be necessary to find a suitable consortium partner, usually another Chinese enterprise, to negotiate and enter into a consortium agreement with. This agreement should cover topics such as sharing of necessary financing, arrangements on operational management post-closing until MAR is finalised, as well as the exit scenario of the other consortium members.
The seller will likely also insist, in cases where a MAR is not a CP, on confirmation that the acquisition of the target business does not form a MAR event. A Chinese investor should expect that, in addition to such confirmation, the seller will likely request an obligation to pay a penalty in the SPA, if it turns out that Chinese authorities do not agree with that opinion.
Last, but not least, a seller will clearly expect a Chinese investor to reimburse all costs and expenses related to the efforts undertaken by the seller, such as production of materials and information, as well as the financials required for finalising the MAR process.
In summary, when considering the impact a MAR event may have on the outbound investment of a Chinese listed company, the steps outlined below should be observed by both investor and seller, in order to prepare the necessary steps for a successful investment.
First, evaluate whether a MAR event could be given, at an early stage of a transaction and in coordination with Chinese authorities. Second, clarify and determine which materials and information need to be provided and what steps need to be carried out for finalising the MAR process. Third, identify whether and to what extent the seller will be able to meet all information requirements under statutory regulations. Fourth, verify whether the MAR process can be finalised prior to closing of the transaction. Fifth, if the MAR process cannot, for whatever reason, be finalised prior to closing, arrange for an alternative solution, e.g., a consortium agreement with other investors – at least until the MAR process can be finalised. Sixth, negotiate a SPA to include MAR related obligations, such as CP definition, detailing the seller’s obligations to deliver materials and information in a specific timeline, penalties/break fee and negotiation of cost reimbursement for the benefit of the seller. Seventh, set up designated teams for the Chinese investor, the seller and the target which coordinate with their respective advisers, to fulfil all regulatory requirements and information requests during the MAR process. Finally, finalise the MAR procedure either pre-closing (if MAR is a CP) or post-closing, in accordance with related SPA provisions.
Dr Nicole Englisch is a partner and Dr Stefanie Tetz is of counsel at Clifford Chance Deutschland LLP. Dr Englisch can be contacted on +49 (89) 21632 8532 or by email: firstname.lastname@example.org. Dr Tetz can be contacted on +49 (89) 21632 8454 or by email: email@example.com.
© Financier Worldwide
Dr Nicole Englisch and Dr Stefanie Tetz
Clifford Chance Deutschland LLP