China Laws and Regulations for PRC Companies Seeking a Listing on HKEx

Transcription

1 China Laws and Regulations for PRC Companies Seeking a Listing on HKEx November 2012 Hong Kong Shanghai Beijing Yangon

2 CHINA LAWS AND REGULATIONS FOR PRC COMPANIES SEEKING A LISTING ON HKEx Slide 1 Two Methods of Listing With the rapid development and further opening up of the Chinese economy, listing on overseas stock exchanges has become an important means for PRC companies to access international funds. Since the first listings of Chinese companies' shares on the Hong Kong Stock Exchange (Exchange) in the 1980s and 1990s, the Exchange has become the overseas listing venue of choice for PRC companies. Historically, there have been two routes for PRC companies to list on the Exchange: directly by way of an H share listing or indirectly via a red chip listing. H share companies are joint stock limited companies incorporated in the PRC which have received approval from the China Securities Regulatory Commission (the CSRC ) to list in Hong Kong. They are different from so-called red chip companies which are incorporated outside the PRC (usually in Hong Kong, the Cayman Islands or Bermuda), have major assets in the PRC and are controlled as to at least 30% of their shares by PRC entities or individuals. For the purposes of quoting statistics, the Exchange uses the term red chip to refer to companies incorporated outside the PRC 1

3 which are controlled by PRC government entities. It uses the term Non-H Share Mainland Private Enterprises to refer to companies incorporated outside the PRC which are controlled by PRC individuals. Slide 2 H-Share Listing The State Council of the PRC published the Special Regulations on the Overseas Offering and Listing of Shares by Joint Stock Limited Companies (the "Special Regulations") in After a period of regulatory uncertainty, it was stipulated in the PRC Securities Law in 1999 that the CSRC shall be the authority responsible for overseeing the listing of Chinese enterprises overseas. The Special Regulations and the PRC Securities Law provided the legal basis on which overseas listings are regulated. To resolve the difference in corporate governance and the company laws between the PRC and Hong Kong, the Exchange and the SFC liaised with the Chinese authorities and introduced the Mandatory Provisions for Companies Listing Overseas (the Mandatory Provisions in The Mandatory Provisions enhance basic shareholder protection under a Chinese company's Articles of Association, to a similar standard to that provided under Hong Kong Company Law. The Mandatory Provisions include provisions relating to the rights of shareholders, directors' fiduciary duties, corporate governance matters, financial disclosures, situations requiring a separate vote by holders of overseas listed 2

4 foreign shares, and a mechanism for resolving disputes by arbitration. Slide 3 H-Share Listing (Cont d) To clarify the procedure and requirements of listing overseas, the CSRC published the Notice on Issues Concerning Enterprises Overseas Listing Applications setting out the requirements for Chinese companies seeking a listing on main boards of overseas stock exchanges (the Notice ). Similar procedure and requirements were also introduced in a notice to regulate listing on the GEM Board of the Hong Kong Exchange. The Notice applies to state-owned enterprises, limited companies and all other forms of enterprises. Enterprise seeking an oversea listing must comply with China s industrial policies, foreign investment policies and regulations of fixed assets investments. This implies that business subject to foreign investment restriction or prohibition or industries that are under state monopoly may face more stringent rules when applying for overseas listing. Whether certain business or industries are the subject of government control or restrictions is largely influenced by the policy momentum of the time. Currently, foreign investment in the areas of high-end manufacturing, hightech development, modern services, new energy, environment protection and energy saving is encouraged by the Chinese government while foreign investment in high polluting and high- 3

5 energy-consuming projects, mining activities of certain natural resources or in industries already suffering from overcapacity, is restricted. For more details, please refer to the Catalogue for Guiding Foreign Investment in Industry which came into effect in January The applicant must also have RMB 400 million of net assets, raise US50 million of funds and have after-tax profit of more than RMB 60 million in the preceding year. This is the so-called Rule. Slide 4 H-Share Listing (Cont d) During the IPO boom year of 2007, there were reports in the press and from investment banks that the CSRC had adopted an unofficial policy of approving overseas listings by Chinese companies only if the amount to be raised exceeds US$1 billion or if the company was prepared to do a dual listing on the Shanghai Exchange. An increase in the amount required to be raised to US$ 1 billion was extremely restrictive. As a result, the trend over the next few years was for large PRC companies to conduct dual listings on the Hong Kong and Shanghai exchanges. The measures, aimed partly at absorbing some of the excess liquidity in the Mainland market, are also fairer to Mainland investors in giving them the opportunity to invest directly in some of the Mainland s best companies which had previously only been available to overseas investors. The aim was also to promote the development of the Mainland stock exchanges. 4

6 Recently however there have been reports that the CSRC is proposing to lower the thresholds for companies to list overseas and to allow more small and medium-sized enterprises and privately owned enterprises to list overseas. In January 2012, the Vice Chairman of the CSRC said that the CSRC plans to both lower thresholds and simplify the approval procedure to allow this during The CSRC does not specify any financial requirements for applicants seeking to list on the GEM but require the applicant: to have been duly incorporated as a joint stock limited company; to not have committed any material breach of relevant laws and regulations for the previous 2 years; to meet the GEM Listing Rule requirements; and to have retained a qualified sponsor to support the application and act as underwriter. Slide 5 H-Share Listing (Cont d) Procedure Three months prior to the submission of Form A1 to the Exchange, the applicant must submit to the CSRC an application form, an approval document given by the provincial government or the relevant ministry with which the applicant is registered and a 5

7 recommendation report given by the overseas sponsor of the applicant. The application form must include an overview of the applicant s history and business, restructuring plan, shareholding structure, compliance record, financial reports covering the three preceding financial years, profit forecast and plan for the use of proceeds. Before appointing parties involved in the listing such as an underwriter and sponsor, the applicant must report to the CSRC a list of potential parties. Five days prior to the submission of Form A1 to the Exchange, the applicant must submit to the CSRC the initial application materials. Ten days prior to the hearing day of the listing application, the applicant must submit the following to the CSRC: approval document given by the State Administration of Industry and Commerce or the Ministry of Commerce; resolution of the applicant in general meeting authorising the listing; confirmation letter from the Administration of State-Owned Assets; confirmation letter from the State Administration of Land concerning land use rights of the applicant; articles of association of the applicant; listing document; restructuring agreement and service agreement; 6

8 legal opinion; audit report, balance sheet and profit forecast; and other documents as may be requested by the CSRC. Slide 6 Round-trip Investment or Red-chip Listing Round-trip investment is the situation where a Chinese resident establishes or controls an offshore holding company and uses the offshore company to control a Chinese company or business, with a view to benefitting from foreign investor status and/or facilitating foreign investment in a domestic business which may be subject to foreign investment restrictions. Slide 7 Round-trip Investment or Red-chip Listing (Cont d) By conservative estimates as much as a quarter of China s official FDI is actually masked as Chinese funds coming home. This structure is also used for preparing companies for offshore listings in Hong Kong, the US or elsewhere. This is known as red-chip Listing. Although red-chip listing initially played a crucial role in attracting foreign investment in domestic companies, with the growth of its own domestic capital markets and the development of its financial services industry and related legal infrastructure, the Chinese government has sought to curtail the use of this structure. 7

9 Moreover, by keeping more IPO transactions on-shore, the Chinese government can absorb excess domestic liquidity in order to curb the inflationary pressure at home. At the same time, currency from abroad can be stopped from entering China which has created appreciation pressure on the RMB. Also, the Chinese government would prefer the parent companies of Chinese companies to be Chinese so as to able it to monitor their shareholdings, control their foreign currency flows and continue to tax them. Slide 8 Round-trip Investment or Red-chip Listing (Cont d) Circular 75 In November 2005, the State Administration of Foreign Exchange of China (the SAFE ) published the Notice on Relevant Issues Concerning Administration of Foreign Exchange for Domestic Residents Financing through Overseas Special Purpose Vehicles and Round Trip Investment, otherwise known as Circular 75. Circular 75 s aim was to tighten the regulatory oversight on the setting up of offshore companies directly or indirectly controlled by onshore entities for the purpose of acquiring domestic equity and assets the first step of red-chip listing. This type of offshore company is defined as a Special Purpose Vehicle ( SPV ) under Circular 75. The target of Circular 75 8

10 Circular 75 applies to a domestic legal person and domestic natural person. While the former conventionally includes any enterprise established under the laws of China, the latter extends to cover not only Chinese residents but also foreign nationals who habitually reside in China for economic reasons. This effectively prevents Chinese residents from circumventing the rules by changing his/her nationality. Slide 9 Round-trip Investment or Red-chip Listing (Cont d) Circular 75 defined round-trip investment as the acquisition of domestic equity or assets through an SPV by: purchasing the shares of the onshore company in cash or with the shares of the SPV (share swap); setting up a wholly foreign-owned enterprise which controls domestic equity or assets; or increasing the authorised capital of the onshore company. Registration with the SAFE is required prior to the setting up of an SPV or the acquisition of domestic equity or assets via the SPV. Moreover, profits, dividends, and foreign exchange income resulting from capital change of the SPV must be remitted to China within 180 days. This practically implies that the proceeds of offshore listing of the SPV have to be remitted to China. The uncertain and cumbersome registration requirement and the remittance requirement make round-trip investment a lot more difficult. 9

11 Slide 10 Round-trip Investment or Red-chip Listing (Cont d) Circular 106 and Circular 77 Subsequent to the introduction of Circular 75, the SAFE published Circular 106 and Circular 77 in 2007 and 2009 respectively to implement Circular 75. The effect of both circulars was to further restrict round-trip investment. First, the onshore target of the SPV must have a minimum operating history of 3 years in order to secure SAFE registration. Second, the definition of round trip investment was expanded to cover Greenfield investments in offshore companies in which no pre-existing domestic equity or assets are involved. The result was that the conversion of a non- SPV offshore company to a SPV or the retroactive registration for an existing but unregistered SPV became impossible. Also, residents that concluded a round-trip investment before completing registration with the SAFE were barred from retroactive registration. Circular 19 Two years later, the SAFE introduced Circular 19 to relax the stringent requirements imposed by Circular 106 and Circular 77. First, the 3-year requirement was removed. Instead, the applicant for round-trip investment only needs to provide a written statement with the consent of all domestic equity owners regarding overseas financing. Second, Circular 19 expressly allows domestic residents 10

12 to conduct direct investment via non-spv. This can be taken to mean that acquisition of domestic equity or assets via an offshore company which has genuine operation and is not set up for evading restriction on round-trip investment will be allowed. Such domestic resident investors do not have to go through the registration process for an SPV before investing in an onshore entity. Third, Circular 19 implicitly allows retroactive registration of an unregistered SPV after the completion of round-trip investment by introducing penalty with clear guidance of calculation. Although the development of the regulatory framework for roundtrip investment via SPV seems to involve many complicated technicalities, the introduction of Circular 19 suggests that although round-trip investment is not welcome by the Chinese authorities, too much restriction is not feasible. Slide 11 Circular 10 the M&A Rules In August 2006, Ministry of Commerce ( MOFCOM ), together with other governmental departments, issued the Provisions on the Takeover of Domestic Enterprises by Foreign Investors (the M&A Rules or Circular 10 ), which came into effect on 8 September Circular 10 represented a significant step in the development of China s regulation of foreign acquisitions of Chinese companies. The requirements imposed by it had significant consequences both for round-trip investments and red-chip listings. Since Circular 10 11

13 has come into force, there have been virtually no approvals for restructurings of Chinese companies into offshore holding companies. This has put a stop to all potential round-trip investments and/or red-chip listings. The key features of Circular 10 are: Require CSRC approval for IPOs involving offshore SPVs holding China assets Impose restrictions on round-trip investments Allow the use of foreign companies shares in the acquisition of China companies (share swap) Require Central MOFCOM approval for foreign acquisition of control of PRC company which involves a key industry, may affect national security or ownership of a well-known Chinese brand Slide 12 Circular 10 the M&A Rules (Cont d) Scope of Circular 10 Circular 10 applies to Equity Acquisitions and Asset Acquisitions. An Equity Acquisition is defined as a foreign investor s purchase of equity in an enterprise other than a foreign invested enterprise ( FIE ) (a Domestic Company ) or the subscription by a foreign investor for new shares in a Domestic Company resulting in the conversion of the Domestic Company to a FIE. 12

14 An Asset Acquisition is defined to include: i. a foreign investor s establishment of a FIE which purchases and operates the assets of a domestic enterprise; and ii. a foreign investor s purchase of assets from a domestic enterprise which are then invested in a FIE established to operate such assets. All acquisitions covered by Circular 10 require MOFCOM approval, either at the central government level or, in certain cases, at the provincial level. Acquisition Price Article 14 of Circular 10 requires that the acquisition price of the equities to be transferred or the assets to be sold must be based on an asset valuation report prepared by a PRC asset valuation company. In order to reflect the government's sensitivity to tax evasion and prohibit diversion of any capital abroad in a disguised form, Circular 10 expressly prohibit setting an acquisition price below the appraised value of the relevant equity interest or assets to be sold as stated in the valuation report. Within these boundaries, the laws and regulations generally allow the parties to freely negotiate the transfer price. However, transactions involving state-owned equity interests or assets must comply with special regulations on the management of state-owned assets. There are 13

15 also separate regulations governing the disposal of assets of stateowned interests. Slide 13 Circular 10 the M&A Rules (Cont d) MOFCOM Approval Requirement Circular 10 requires that MOFCOM approval at the central government level must be obtained where an offshore company established or controlled by a Chinese company or individuals is to acquire a Chinese company affiliated with such person(s). This is the case irrespective of the amount of the transaction and the industry in which the Chinese company is involved. The requirement for MOFCOM approval at the central government level has made it significantly more difficult for Chinese companies to be restructured under an offshore holding structure. Circular 10 also imposes an obligation on the parties to an acquisition to declare whether they are affiliated. If two parties to a transaction are under common control, the identities of the ultimate controlling parties must be disclosed to the approving authorities, together with an explanation of the purpose of the M&A transaction and a statement as to whether the appraised value represents fair market value. The use of trusts or other arrangements to avoid this requirement is expressly prohibited. (Article 15) Slide 14 14

16 Circular 10 the M&A Rules (Cont d) SPV SPV is defined narrowly under Circular 10 as an overseas company that is directly or indirectly controlled by a Chinese company or Chinese individuals and is established for the purpose of achieving an overseas listing of shares owned by them in such Chinese company. The use of an offshore SPV to achieve an offshore listing of a Chinese company is effectively prevented by Circular 10, since MOFCOM approval at the central government level is required for the acquisition by the offshore SPV of the affiliated Chinese company and CSRC approval is additionally required for the listing of the SPV on an overseas stock exchange. A further hurdle to a red chip listing is that Circular 10 provides that the listing price of the SPV s shares on the overseas exchange may not be less than the valuation of the onshore equity interest as determined by a PRC asset valuation company. There is also a requirement that the proceeds of the offshore listing, as well as dividends and the proceeds of changes in the capital of domestic shareholders must be repatriated to China within 180 days / 6 months. These restrictions limit the offshore exit options for venture capitalists. Another major difficulty is timing. Where the shares of the offshore SPV are swapped for those of its affiliated Chinese company, Circular 10 requires that the offshore SPV must complete its listing 15

17 on an overseas exchange within one year after the Chinese company receives its new business licence. MOFCOM s approval of the share swap will automatically become invalid if the offshore SPV fails to complete its listing within that time limit and the Chinese company s shareholding structure will be required to be returned to that existing immediately before the share swap. Slide 15 Circular 10 the M&A Rules (Cont d) Share swaps by foreign acquirers A major new development implemented by Circular 10 is that they allow new or existing shares in an overseas company to be used as consideration in the acquisition of shares of a Domestic Company, in lieu of cash payments. The permitted use of share swaps opened an important financial channel for foreign investors. The requirements that must be met include the following: the overseas company must be legally established in a jurisdiction that has a well-developed legal system governing the regulation of companies; except in the case of a special purpose vehicle (SPV), the overseas company must be a company listed in a jurisdiction with a comprehensive system of securities exchange; the overseas company and its management must not have been sanctioned by any supervisory authority during the preceding three years; 16

18 the shares must be legally held and be lawfully transferable in accordance with applicable laws; title to the shares must not be the subject of any dispute and the shares must not be subject to any lien or other encumbrance; the shares in the overseas company (other than a SPV) must be traded on a recognised overseas securities exchange (other than an over-the-counter exchange); and the traded prices of the overseas company s shares (other than in the case of a SPV) must have been stable for the year preceding the acquisition. The Chinese Company or its shareholders must engage an M&A consultant registered in China ( M&A Consultant ). A law firm, accountancy firm or investment bank may apparently act as an M&A Consultant. The M&A Consultant is responsible for conducting due diligence as to the accuracy of application documents, the financial status of the overseas company and compliance with the requirements of the M&A Regulations. The Acquisition Consultant must also issue an opinion as to compliance with the M&A Regulations. MOFCOM approval at the central government level is required for all transactions in which foreign investors use equity as consideration for shares in Domestic Companies (Article 32). If approval is granted, MOFCOM will issue a Certificate of Approval which is valid for six months from the date of issue of the business licence. If the share swap is not completed within that six-month 17

19 period, the Certificate of Approval will become invalid and the transaction will be required to be unwound. Slide 16 Circular 10 the M&A Rules (Cont d) National Security Review Circular 10 also introduced a requirement to report to Central MOFCOM a transaction which results in foreign investors acquiring actual control of a Chinese enterprise and which: i. involves any key industry; ii. iii. will or may affect national economic security ; or may result in a change of control of a domestic enterprise owning well-known trademarks or traditional Chinese brands. If parties fail to report a transaction, MOFCOM and other relevant authorities may require the termination or unwinding of the transaction or measures to mitigate any adverse impact of the transaction on the state economy. No guidance on the meaning of terms such as key industries or national economic security, which has given rise to criticism from the OECD which has stated that these provisions should be more clearly defined. Anti-competition 18

20 Circular 10 contains antitrust provisions requiring a foreign investor s acquisition of a domestic company which gives rise to antitrust issues to be reported to MOFCOM. In August 2009, MOFCOM issued amendments to Circular 10 to bring the anti-competitive provisions into line with the Anti- Monopoly Law ( AML ) and the Provisions on Thresholds for Prior Notification of Concentrations of Business Operators issued by the State Council in August 2008 (the Provisions on Thresholds for Prior Notification ). The most important change made by the amendments is that the original chapter 5 regarding Anti-Monopoly Investigation has been replaced with a new Article 51. This requires that if an acquisition of a domestic enterprise by a foreign investor reaches the thresholds that apply under the Anti-Monopoly Law to require notification of a merger, the transaction must be reported to MOFCOM in advance. A transaction must not be implemented if it has not been reported to MOFCOM. The relevant thresholds as set out in the Provisions on Thresholds for Prior Notification are: (i) EITHER the combined worldwide turnover of all business operators involved in the concentration exceeded RMB 10 billion in the previous financial year OR the combined China revenue of all business operators involved in the concentration exceeded RMB 2 billion in the previous financial year; AND 19

21 (ii) the China revenue of each of at least two business operators exceeded RMB 400 million in the previous financial year. The Provisions on Thresholds for Prior Notification also provide that even where the specified thresholds are not met, MOFCOM may investigate a transaction if there is evidence that the transaction may eliminate or restrict competition in China. Before the amendments were made, Chapter 5 contained reporting thresholds which, in different circumstances, included determination of business turnover, market share, the number of enterprises acquired in a related industry in China, and assets in China. Following the amendment, business turnover became the major factor relevant to whether a transaction is required to be reported to MOFCOM for approval. Slide 17 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors One of the most significant developments of 2011 has been the establishment by the Chinese regulators of a new national security review system for foreign acquisitions of Chinese businesses and assets. The new system is set out in two sets of provisions: (1) The Notice on Establishment of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( Circular 6 ) published by the General 20

22 Office of the State Council which came into effect on 5 March This sets out the broad principles of the national security review system including the industry sectors and transaction types subject to review; and (2) The Regulations on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( Circular 53 ) published by MOFCOM. These came into effect on 1 September 2011 and replaced the interim regulations issued by MOFCOM in March 2011 which had a trial period which ended on 31 August Circular 53 deals with the procedures for implementation of the new review system. It is thought that national security (under the AML) refers to a list published by the State Council in December 2006 of strategic sectors in which the State would retain control. The strategic sectors include military-related manufacturing, power production and grids, petroleum, gas and petrochemicals, telecom manufacturing, coal, civil aviation and shipping. Neither Circular 10 nor the AML set out details of the review process. The implementation of Circulars 6 and 53 should therefore provide foreign investors with greater clarity as to the types of transactions that are required to be subject to national security review and the procedures to be followed in such cases. Slide 18 Establishment of a New National Security Review System for 21

23 M&A of Chinese Enterprises by Foreign Investors (Cont d) Circular 6 Industry Sectors Subject to Review A national security review will be required for: (1) A foreign investor s acquisition of an interest (which need not be a controlling interest ) in a Chinese company involved in the military and national defence industries or related industries or which is located near major sensitive military facilities, and (2) A foreign investor s acquisition of actual control of a Chinese company involved in a sensitive sector, such as important agricultural products, important energy and resources, important infrastructure facilities, important transport services, key technology and the manufacture of major equipment, etc., which may affect national security. Slide 19 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) Circular 6 (Cont d) Actual Control Different thresholds are set for the requirement for a national security review. In relation to M&A of Chinese enterprises in the second category above, the transaction will only require a national security review if the foreign investor would acquire actual control 22

24 over the domestic enterprise via the M&A transaction. Circular 6 provides that a foreign investor will acquire actual control if it becomes the controlling shareholder or de facto controller of the Chinese enterprise, which it will do in the following circumstances: (a) A foreign investor, its parent company and subsidiaries together hold 50% or more of the shares of the Chinese enterprise after the M&A; (b) Multiple foreign investors hold 50% or more of the shares of the Chinese enterprise after the M&A; (c) A foreign investor holds less than 50% of the shares of the Chinese enterprise after the M&A, but the voting rights actually enjoyed by the foreign investor are sufficient to exert a major influence on the resolutions of the shareholders or the board of directors; or (d) Other circumstances exist which may result in the foreign investor gaining actual control of matters such as business decisions, financial affairs, human resources, technologies, etc. No guidance is however given as to what will constitute a major influence on board and shareholders resolutions. Slide 20 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) 23

25 Circular 6 (Cont d) Transaction Types subject to Review According to Circular 6, the following types of M&A transactions involving a Chinese enterprise and a foreign investor will be subject to the security review process: (a) A foreign investor's purchase of the existing equity of a nonforeign-invested enterprise in China, or its subscription for newly issued equity of a non-foreign-invested enterprise in China, thereby converting such enterprise into a foreigninvested enterprise ( FIE ); (b) A foreign investor's purchase of the existing equity of an FIE from Chinese shareholders or its subscription of new equity of an FIE; (c) A foreign investor establishes an FIE, and either: (i) purchases and operates the assets acquired from a domestic enterprise through such FIE; or (ii) purchases the equity of a domestic enterprise through such FIE; or (d) A foreign investor purchases the assets of a domestic enterprise directly and uses the purchased assets to invest and establish an FIE to operate such assets. A point to note is that the types of M&A transactions which are subject to review under Circular 6 are broader than those under the M&A Rules. MOFCOM clarified in guidance published in 24

26 December 2008 (the Foreign Investment Examination and Approval Management Handbook ) that a foreign investor s purchase of equity of an existing FIE is not subject to the M&A Rules. Under Circular 6, however, such a transaction would be subject to national security review. Slide 21 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) Circular 6 (Cont d) Relevant Factors in the Security Review The factors which are taken into account in determining whether an M&A transaction should be approved or blocked are as follows: (1) the impact of the M&A transaction on national security, including the domestic product manufacturing capacity, domestic service provision capacity, and relevant equipment and facilities needed for the national security; (2) the impact of the M&A transaction on the stable operation of national economy; (3) the impact of the M&A transaction on social order; and (4) the impact of the M&A transaction on the research and development capabilities for key technologies related to national security. Slide 22 25

27 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) Circular 53 Anti-Avoidance Circular 53 makes clear that in determining whether an M&A transaction should be the subject of a national security review, MOFCOM will look at the substance and actual impact of the transaction, rather than just the form of the transaction. In particular, it specifies that foreign investors should not seek to avoid the national security review process by any means, including, without limitation, the use of nominee shareholding structures, trusts, multi-level investment and reinvestment structures, leases, loans, contractual control arrangements and offshore transactions. Accordingly certain transactions which previously fell outside the scope of MOFCOM s review, such as where foreign investors retain control under contractual provisions, are now subject to scrutiny. It is likely that this provision will have significant implications in terms of structuring PRC M&A transactions. In particular certain structures (such as so-called VIE structures) which involve contractual provisions giving foreign investors de facto control may be subject to MOFCOM scrutiny where the transaction impacts national security. The VIE structure has been used widely to circumvent restrictions on foreign investment in certain industries and the restriction on so-called round trip investments by Chinese residents. 26

28 Slide 23 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) Circular 53 (Cont d) The Security Review Process The national security review process can be commenced in one of 3 ways: (1) The foreign investor or investors involved in the M&A of a domestic enterprise can file an application for security review with MOFCOM which will carry out a preliminary review. Only Central MOFCOM is competent to conduct such national security review whereas applications for general foreign investment approval can be made either to Central MOFCOM or to MOFCOM S regional offices, depending on the total investment amount in the case of M&A transactions under the M&A Rules. (2) The review process can be initiated by a third party such as government agencies, national industry associations, enterprises in the same industry and enterprises upstream or downstream of the target (e.g. customers or suppliers). However, neither Circular provide for whether initiation of the security review process by a third party must occur before completion of the acquisition or whether it is possible to commence the process after its completion. (3) The process may commence following a referral from a regional MOFCOM office. Where a foreign investor makes 27

29 an application to a regional MOFCOM office in respect of an M&A transaction and does not file also file a national security review application with Central MOFCOM, the regional MOFCOM office will suspend its foreign investment approval procedure of the M&A transaction and require the foreign investor to submit a separate application for national security review to Central MOFCOM if it considers that a national security review may be required. The regional MOFCOM office will also report the case to Central MOFCOM. Where the foreign investor involved in the M&A applies for a national security review it must submit the following documents: A written application for national security review and a description of the M&A transaction; Notarized and authenticated certificates of registration and creditworthiness for each foreign investor; A description of the foreign investor and its affiliates (including its actual controller and parties acting in concert) and of the investor s relationship with the government of its home country; A description of the target Chinese enterprise together with its articles of association, business license, audited financial statements for the previous year, an organizational structure chart before and after the M&A, and a description of its subsidiaries together with copies of their business licenses; The contract, articles of association or partnership agreement of the FIE to be established after the M&A; 28

30 In the case of an M&A involving an equity acquisition, the equity transfer agreement or the foreign investor s agreement to subscribe for new equity; In the case of an M&A involving an asset transfer, the resolution of the Chinese enterprise s ultimate decision making body (or property rights owner) approving the sale of the assets, the assets purchase agreement and an asset evaluation; and A description of matters relevant to the question of whether the foreign investor will acquire actual control (e.g. as to its voting rights and ability to exert a material influence on shareholders and board resolutions and control of the Chinese enterprise s business decision making, financial matters, human resources, etc.); Any other documents required by MOFCOM. Prior to filing an application with MOFCOM, a foreign investor may request a meeting with MOFCOM to discuss procedural issues relating to a proposed transaction. It is however specifically stated in Circular 53 that the results of the discussion are not binding on MOFCOM and cannot be relied on by a foreign investor to determine whether it should apply for national security review. Slide 24 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) Circular 53 (Cont d) 29

31 The preliminary national security review of an M&A transaction involving a foreign investor is carried out by Central MOFCOM. The new regime also established an inter-ministerial panel (the Ministerial Panel ) led by the State Council with responsibility for substantive and final review. The Ministerial Panel is also made up of members of the National Development and Reform Commission and MOFCOM who are required to take the lead in carrying out the M&A security review in consultation with other relevant departments according to the industries and fields involved in the foreign M&A. M&A Security Review Timeline (1) Once MOFCOM receives an application for national security review it will consider whether the application is complete. If it is, MOFCOM will notify the applicant in writing that the application has been accepted. (2) If MOFCOM considers that the M&A transaction should be referred to the Ministerial Panel for national security review, it will forward the application to the Ministerial Panel within 5 working days. (3) MOFCOM will then notify the applicant in writing within 15 working days that the application has been referred for national security review. 30 During that period, the M&A transaction and any approval procedure being conducted at any regional MOFCOM office must be put on hold. If the applicant is not notified that a national security review will be

32 conducted within 15 working days, it may proceed with the transaction without regard to national security issues. Slide 25 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) (4) If an M&A transaction is submitted to it for review, the Ministerial Panel will first conduct a general review which is conducted by the collection of written opinions. Parties to the transaction are required to cooperate with the Ministerial Panel in its conduct of the review and to provide materials and information required for the review. On receipt of the referral from MOFCOM, the Ministerial Panel has five working days to solicit opinions in writing from relevant government departments, which are required to submit written opinions within 20 working days. (5) If all relevant departments agree that the relevant M&A transaction will not have any impact on national security and a special review is unnecessary, the Ministerial Panel will inform MOFCOM in writing within five working days. MOFCOM will then inform the applicant and the regional MOFCOM office within a further five working days of receipt of the Ministerial Panel s written decision. (6) If one or more of the government departments consulted considers that the relevant M&A transaction may affect national security, the Ministerial Panel will initiate a special 31

33 review procedure within five working days of receipt of the departments written opinions. (7) The special review procedure may take up to 60 working days at the end of which the Ministerial Panel will inform MOFCOM in writing of its decision. MOFCOM will then inform the applicant. However, if there is a significant disagreement among members of the Ministerial Panel as to whether the M&A transaction will impact national security, the transaction must be referred to the State Council for a decision. No time limit is however set for the making of the State Council s decision. Slide 26 Establishment of a New National Security Review System for M&A of Chinese Enterprises by Foreign Investors (Cont d) Circular 53 (Cont d) Security Review Potential Outcomes The new regime provides for 3 possible outcomes: (1) If the transaction will not impact national security, the applicant can proceed with the transaction subject to obtaining other necessary foreign investment approvals; (2) If the transaction is likely to impact national security and has not yet been implemented, the relevant parties must terminate the transaction. The parties may subsequently make adjustments to the transaction but will need to reapply 32

34 for a national security review; and (3) If the transaction has already had, or may have, a material impact on national security, MOFCOM and other relevant departments will terminate the transaction or require that other remedial measures are taken, such as the equity or asset transfers, to eliminate the transaction s threat to national security. The new national security regime has only been in place for less than 2 years and it is difficult at this stage to assess its potential impact. This is particularly true given that there is no requirement for review decisions of the Ministerial Panel to be made public. One particular difficulty is that the Circulars do not clearly define the industries which require national security review, the list provided in Circular 6 is broadly worded and non-exhaustive making it difficult for foreign investors to assess whether a proposed transaction will require national security review. Another concern that has been raised is that the express prohibition on the use of contractual control arrangements to circumvent the national security review may signal the Chinese authorities intention to regulate the VIE structure on a wider basis. Slide 27 Circular 10 the M&A Rules (Cont d) The impact This effective prohibition on round-trip investments was confirmed in the Foreign Investment Examination and Approval Management 33

35 Guidance Handbook issued by MOFCOM in December The Handbook states that MOFCOM will only consider the approval of a round-trip investment application in two situations: (i) If the offshore acquirer is a listed company; or (ii) If (a) the formation of the offshore acquirer has been duly approved; (b) the offshore acquirer has commenced operations; and (c) the offshore acquirer will fund the acquisition from profits. With these two exceptions, the majority of round-trip transactions continue to be prohibited. Circular 10 did not however put a stop to offshore financings and listings of Chinese companies. The number of both has remained high, although many such deals involved companies that were restructured prior to Circular 10 s effective date. Slide 28 VIE structures Alternative structures have been used to address the challenges to round trip investments posed by Circular 10 and Circular 75. Many of these have involved variations on the VIE structure or JV structure. Under a VIE structure, the domestic operating company engaging in a business or industry subject to restrictions on foreign 34

36 investment is typically wholly owned by the domestic shareholders, and the foreign investors control and obtain economic benefits from the domestic operating company through a series of contractual arrangements. The VIE structure was first adopted by Sina in its 2000 listing on Nasdaq, followed by a number of leading internet or media companies listed overseas, including Sohu, Netease, Baidu, Focus Media, Youku and Dangdang (all listed on Nasdaq or NYSE) and Tencent and Alibaba (both listed on HKSE). Over the years, the VIE structure has never been officially or publicly blessed by the PRC authorities, and it has been sometimes regarded as a structure established to intentionally circumvent the restrictions on foreign investment. Yet, it appears that it has been at least acquiesced by the Chinese regulatory authorities. Slide 29 VIE structures (cont d) A typical VIE structure is illustrated in the following diagram: 35

37 In a typical VIE structure, all relevant operating licences and permits required for the operation of the restricted business will be held by the domestic operating company which is wholly owned by the domestic shareholder. The domestic shareholder and the foreign investor will jointly establish an offshore SPV (which will normally be the listed co) to directly or indirectly hold a WFOE. The WFOE will normally own various domestic companies engaging in the non-restricted business. Slide 30 Typical contents of contractual arrangements between domestic company and the WFOE Control over the domestic operating companies is exercised through a series of contractual arrangements between (1) the domestic shareholder and the WFOE; and (2) the domestic operating company and the WFOE. These contractual arrangements will normally include: 36

38 (a) (b) (c) (d) (e) Exclusive service agreement; Call option agreement; Equity pledge agreement; Loan Agreement; and Voting right agreement or power of attorney. Exclusive Service Agreement The exclusive service agreement is entered into between the WFOE and the domestic operating company pursuant to which the WFOE provides exclusive consulting, management or technology support services to the domestic operating company for a fee for the purpose of shifting the profits of the domestic operating company to the WFOE. Call Option Agreement The call option agreement is entered into between the WFOE and the domestic shareholder pursuant to which the WFOE is granted the option to acquire or designate a third party to acquire, all or a portion of the equity interest in the domestic operating company at the lowest permitted price under the applicable PRC laws and regulations. Equity Pledge Agreement 37

39 The equity pledge agreement is entered into between the WFOE and the domestic shareholder, pursuant to which the domestic shareholder pledges all its equity interests in the domestic operating company in favour of the WFOE to secure the due performance of the domestic operating company of its obligations under the contractual arrangements. The equity pledge agreement is required to the registered with the local Administration of Industry and Commerce to perfect the security interest. Loan Agreement The loan agreement is entered into between the WFOE and the domestic shareholder, pursuant to which the WFOE grants a loan to the domestic shareholder for the purpose of capitalising the domestic operating company. Voting Rights Agreement or Power of Attorney The voting rights agreement or power of attorney is entered into between the WFOE and the domestic shareholder pursuant to which the domestic shareholder irrevocably grants the WFOE all its shareholder rights, including voting rights. Slide 31 Risks involved 38

40 However, just because VIE structures have been widely used does not mean they are legally risk-free. The continued existence of VIE structures very much depends on the policy-winds among government officials. The risks associated with use of the VIE structure essentially fall into two categories: (i) the regulatory risk that the structure might be declared to be invalid by the PRC authorities; and (ii) the risk that the contractual arrangements on which it relies will be unenforceable or insufficient to retain control over the domestic operating company. With regard to both these issues, comfort need to be sought from the PRC legal advisers. The principal regulatory risk probably arises where the domestic operating company operates in a sector which is subject to restrictions on foreign investment. Although the foreign investor does not directly own equity in the domestic operating company, there is the possibility that the Chinese regulatory authorities could regard it as de facto foreign investment. Failure to obtain the required foreign investment approvals could lead to the Chinese authorities requiring the structure to be unwound. Another risk is that VIE structures could be declared to be subject to the requirement for MOFCOM approval under the M&A Rules. Use of the VIE structure to facilitate foreign investment in areas subject to restrictions on such investment has however been common for a number of years and many of China s best known companies have used the structure to obtain foreign venture capital financing and list offshore. 39

41 With regard to future changes to regulations, PRC legal advisers will usually include in their legal opinion an opinion that on the basis of the principle of non-retrospectivity of laws under the Legislation Law of the PRC and other relevant laws and regulations, if laws, rules or regulations governing VIE structures should be adopted in the future, the status of existing VIE structures and contractual arrangements should not be affected. Concerns of a clamp down on the use of the VIE structure have been fuelled in part by attempts by individual PRC regulators to restrict or curtail the use of the structure in specific industries or to circumscribe its use. For example, in relation to value added telecommunications businesses, a circular issued by the PRC Ministry of Information Industry in 2006, requires certain key assets, including trademarks and domain names, to be held by the company with the value added telecommunications service provider licence or its shareholders. As a result, in a VIE structure, the domestic operating company needs to hold key assets and cannot lease or license them from the WFOE. Although this increases the potential loss suffered by the WFOE if it loses control of the domestic operating company, the circular can also be regarded as acknowledging the use of the VIE structure in the value added telecommunications industry. Another example is the notice of general administration of press and publication issued in targeting the online gaming business. Under the notice, foreign investors are not allowed to control or participate in a domestic online gaming business by 40