Legal Digest An online repository of various articles published by our lawyers

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1 An online repository of various articles published by our lawyers PRC Companies Going Public Legal And Due Diligence Issues Chia Kim Huat 1 Rajah & Tann 4 Battery Road #26-01 Bank of China Building Singapore Tel: Fax: eoasis@rajahtann.com Website:

2 PRC Companies Going Public Legal And Due Diligence Issues Chia Kim Huat INTRODUCTION The number of PRC listings on the Singapore Stock Exchange will hit a record high this year. There are many reasons that contribute to this phenomenal growth. First, the emergence of privately-owned enterprise in China. Prior to 1978, the entire Chinese economy was virtually state-owned. Private enterprises did not have any legal status under the communist ideology. It was not until 1988 that the PRC constitution was amended to recognise the existence of such private enterprises and the contributions made by such enterprises to the PRC economy was given further recognition in the 1999 amendment to the PRC Constitution. By then, many private entrepreneurs and conglomerates had already emerged in China. Some were previously employees of ailing state-owned companies who bought over such companies and turned them into profitable enterprises. Some took advantage of China s open door policy and grew big by partnering foreign investors, drawing in foreign funds and importing foreign technology. There were also others who just rode on the rising Chinese economy and prospered by investing in growth sectors. As such, it is not surprising that the first few PRC companies that appeared on the Singapore Stock Exchange in the 1990s were mainly state -owned companies. It was not until the turn of this century that we saw a spate of private enterprise listings on the Singapore Stock Exchange. Second, the lack of listing opportunities on the PRC stock exchanges. China has two established stock exchanges, one in Shenzhen and the other in Shanghai. In terms of size, the total number of companies listed on these two stock exchanges stand at 508 and 715 respectively as at the end of 2002, and the combined market capitalisation of the two stock exchanges is a staggering RMB3.8 trillion. Notwithstanding the above statistics, PRC private companies still find it difficult to get the coveted approvals for listing on the PRC stock exchanges. Those who are familiar with the PRC stock market will know that there is a quota for the number of companies that can be listed on the PRC stock exchanges. Such listing opportunities are often given to state-owned enterprises and large conglomerates with good guanxi (ie, connections). The queue is long and it can be frustrating for companies looking for urgent funding to fund their expansion. Third, the success of foreign investment in China. With China s accession to the World Trade Organisation, growth sectors that were previously prohibited or restricted are now available for foreign investment. Those who have already invested in China are now able to set up in more locations, as well as increase their equity stake in their joint ventures (including turning them into wholly-owned subsidiaries). This has led to higher profitability and better prospects for some foreign companies. Several of the China concept stocks listed on the Singapore Stock Exchange recently are the holding companies of such foreign investment enterprises. Fourth, change in the PRC regulatory control. Prior to March 2003, any listing of foreign companies with substantial PRC assets required a no -objection letter from the China Securities Regulatory Commission ( CSRC ). This was the case whether such foreign companies were wholly-owned by Page 1

3 foreigners, or partially or wholly-owned by PRC individuals or entities. This requirement made it extremely difficult and tedious for PRC private enterprises to list overseas. Even for foreign companies without any PRC shareholders, the CSRC review was by no means a formality. It was not uncommon to find the CSRC raising issues that might not be strictly within its scope of review. Although the official period of review was 15 days, the actual process would usually take three months to complete and there was no assurance that the no-objection letter would be given at the end of the review. In the event that there were any changes in shareholding or substantial change in the PRC business or assets during the review period, the review process would have to be re-started. Given the number of such listings and the limited resources available at the CSRC, an informal queue developed. This gave rise to more uncertainty as time is of the essence in the listing process. The CSRC no-objection letter requirement was eventually abolished by the PRC State Council on 27 February Fifth, favourable conditions in the Singapore stock market and active marketing by the Singapore Stock Exchange. The Singapore stock market has been fairly attractive for new listing aspirants. The P/E in Singapore is higher than some other exchanges in the region for certain industries and the PRC-related IPOs have generally performed well, with several of the issues many times oversubscribed. The Singapore Stock Exchange has also been very active in China, conducting seminars and meeting potential IPO candidates to explain the benefits of a listing on the Singapore Stock Exchange. Together with the many Singapore professionals and consultants who are active in China, they have helped to raise the profile and awareness of the Singapore stock market. PRC Legal Issues PRC equity listings can generally be classified into the following categories: (a) Primary Listing A direct listing by a PRC company of its shares on the Singapore Stock Exchange, more commonly known as the S-Shares listing. The only PRC S-Share listing on the Singapore Stock Exchange todate is Tianjin Zhong Xin Pharmaceutical Group Corporation Limited. (b) Secondary Listing A listing of shares by a PRC company that is already listed on another stock exchange. One example is the China Merchants Shekou Holdings Co Ltd (formerly China Merchants Shekou Port Service Company Limited). The company was already listed on the Shenzhen Stock Exchange when it came to Singapore for a secondary listing in (c) Red Chip Listing A listing by the overseas holding company of the PRC company. This is the route taken by most PRC private enterprises, such as Hongguo International Holdings Limited. The PRC companies usually go through a reorganisation process to create an overseas listing entity. The shareholders of the PRC private enterprise will then hold shares in the overseas listing entity. (d) Reverse Takeover An injection of PRC assets and businesses into an existing Singapore listed company in exchange for a controlling stake in the listed company. Depending on the terms of the acquisition, the Singapore listed company can be just a listed shell (ie, a company with no principal business or its existing controlling shareholder has undertaken to Page 2

4 buy over the existing business) or there can be a joint venture of sorts, whereby the existing and new controlling shareholders will jointly manage both the Singapore and PRC businesses. One such example is Pakara Technology Limited, a company listed on SESDAQ. (e) FIE Listing A listing by foreign investors of the overseas holding company of their PRC businesses. Most foreign investors set up a special purpose vehicle to hold their PRC investments. Unlike the Red Chip listing, there are usually no PRC investors in the overseas holding company. Dragon Land Limited is one such example. Depending on the type of equity listing, different PRC laws and approvals are applicable. Primary / Secondary Listing If a PRC company is seeking a listing on the main board of the Singapore Stock Exchange, it will need to comply with the Notice issued by CSRC in 1999 on Questions relating to Applications by Companies for Overseas Listing. Under the Notice, the company is required to meet certain conditions, including what is commonly known as the 4, 5, 6 requirement; namely, the company must have a net asset value of not less than RMB400 million, the funds proposed to be raised by the company should not be less than US$50 million and the net profits after tax of the company for the preceding year should not be less than RMB60 million. These are only the basic requirements. Even if a company can satisfy the above requirements, there is no assurance that approval will be given by CSRC for the overseas listing. To date, the PRC companies that have obtained CSRC s approval for such overseas listings are mainly large PRC state-owned conglomerates. If it is a SESDAQ listing, then the above Notice is not applicable. The PRC company, however, will need to comply with the Directive issued by the CSRC on Approval and Supervision Guidelines for Companies applying for listing on the Hong Kong GEM Board. There is no minimum net asset value, funds raised and profits requirement under the Directive. Although the threshold is lower, the application would still need to be approved by CSRC and the process is not a mere formality. Red Chip Listing The main legislation in this area is the Notice issued by the PRC State Council in 1997 on the Further Strengthening of the Administration of the Issue and Listing of Shares Overseas, more commonly known as the Red Chip Notice. Under the Red Chip Notice, a listing of an overseas company majority controlled by PRC interests requires the approval of the CSRC and the PRC State Council Securities Commission in certain circumstances. In order to avoid the need to obtain the aforesaid approvals, a lot of attention is given to the restructuring of the PRC companies. A typical structure includes the setting up of a new overseas company ( Holdco ), usually in a tax haven such as the Cayman Island, Bermuda or British Virgin Islands. The Holdco will then be used as the vehicle to acquire the PRC com panies, businesses and assets intended for overseas listing. This used to be a fairly straightforward process as the main requirement is to comply with the PRC Foreign Investment Guidance Catalogue and to obtain the approval of the relevant Ministry of Foreign Trade and Economic Cooperation (now known as the Ministry of Commerce). Page 3

5 However, with effect from April 2003, the above acquisition will also need to comply with the Interim Regulations on the Merger and Acquisition of Domestic Companies by Foreign Investors ( M&A Regulations ). Under the M&A Regulations, the acquisition price cannot be lower than the appraised value of the companies, businesses and / or assets to be acquired by Holdco and where necessary, creditors approval would also need to be obtained. Holdco is also required to inject foreign exchange to pay for the acquisition price within a certain period. Such funding requirement may pose a problem for PRC companies with no foreign exchange reserve. Reverse Takeover Under the Red Chip Notice, PRC companies are not permitted to acquire listed shell company. Some PRC lawyers have construed the restriction as being applicable to PRC state-owned and collectiveowned enterprise, and not applicable to acquisition of listed shell company by PRC individuals, especially those who have obtained overseas citizenship or permanent residency. There has been no official interpretation on this condition and CSRC officials have been known to have given differing views on this issue. FIE Listing This form of listing attracts the least PRC regulatory concern as the majority shareholders are foreign investors. It used to be that CSRC no-objection letter is required as the main business/assets of the company are located in China. With the abolition of the no -objection letter requirement, the main hurdle for such listing (so far as PRC issues are concerned) is the due diligence process as discussed below. PRC Due Diligence The due diligence process in China is generally not very different from that in any other country. However, there are several aspects that are worth mentioning. Lack Of Search Facilities Most cities in PRC do not have a proper record system that is open to the public for inspection. As such, it is not easy to carry out independent searches on the status of the company, title to property and assets, as well as legal proceedings. Professionals can only rely on interviews with management and representations by the company and its officers, as well as inspection of the records maintained by the company, to gather the relevant information. Under Declaration Of Taxes It is rare to find a PRC company that declares its taxes fully and promptly, but that is not to say that none exists. By way of background, PRC domestic companies pay income tax at the rate of 33%, whereas foreign investment enterprises ( FIE ) pay taxes ranging from 15% to 33%, depending on where it is located and the type of business activity that it is involved in. In addition, an FIE also enjoys generous tax holidays that are not extended to PRC domestic companies. As such, to remain competitive, it is not surprising to find PRC companies engaging in some form of creative accounting so as to minimise their tax burden. These issues, however, would need to be Page 4

6 resolved prior to listing and the amount of unpaid taxes can amount to millions of dollars in some cases, especially for companies that have been operating profitably for several years. No Proper Accounting Apart from tax issues, PRC companies generally do not maintain their accounting records according to international accounting standards. Most of the companies do not have sufficient bad debt provision, do not provide for depreciation expenses, fail to write down inventory and do not record proper sales even though the goods have been sold and delivered. The essential financial figures of a listing aspirant may look very different after adjustment in accordance with Singapore GAAP or IAS. Social Security Payment Apart from wages, there is a long list of welfare, medi cal and social security payments that a PRC company needs to provide for its employees. It is not uncommon to find companies not complying fully with its social security obligations as such additional payment can amount to 50% of an employee s wages. Failure to comply with such social security obligations is a clear violation of the law and may lead to drastic consequences. Land Use Rights The concept of ownership, lease or right to use land is not often understood by PRC companies. Quite a number of them have title defects issue as they may not have paid for the land or does not have proper legal rights to reside on the land. In some cases, local government has even given free land to companies in a bid to attract them to set up their factory there and create employment (and consequently, tax income). Such give away is usually beyond the scope of authority of the local government but it is always difficult to convince the companies that they should volunteer payment for the land when the local government is saying that no payment is required. Intellectual Property Rights PRC companies are usually quite weak in the protection of their intellectual property rights. Some of them do not register their trademarks or patents. The more enterprising ones even copied and modified international famous marks or patents and passed them off as their own. Conflict Of Interest The promoters of the companies are usually engaged in other similar businesses, which are not always possible to be brought under the listed company. At the same time, most PRC companies are family run, especially so in the smaller towns and cities. The key supplier of the company may be a distant relative of the promoter and the buyer may well be related to the wife or the in-laws of the promoter. Valuation Due to the lack of transparency and market data, and given the fact that China has just embraced the market economy for a relatively short period of time, it is not easy to obtain an accurate valuation for Page 5

7 property and assets in China. Very often, the valuation results from different valuers can differ by as much as 100% or more. The above issues are by no means exhaustive. Professionals will need to be extra careful when carrying out due diligence in China. The ability to read and communicate in Chinese is essential, as a lot of information is extracted through interviews with management, discussions with officials and inspection of Chinese records. CONCLUSION As the PRC Economic Express surges ahead, many more PRC companies will qualify for listing on PRC and foreign stock exchanges. Singapore will get its fair share of such listings, provided that we remain diligent and proactive in attracting such companies to Singapore. The challenge however is to get the better and bigger companies to be listed here! This article first published in PULSES (2003). Rajah & Tann is one of the largest law firms in Singapore. It is a full service firm and given its alliances, including US premier firm Weil, Gotshal & Manges, is able to tap into a number of countries. Rajah & Tann is firmly committed to the provision of high quality legal services. It places strong emphasis on promptness, accessibility and reliability in dealings with clients. At the same time, the firm strives towards a practical yet creative approach in dealing with business and commercial problems. The information contained in this newsletter is correct to the best of our knowledge and belief at the time of writing. Specific professional advice should be sought before any action is taken. In this regard, you may call the lawyer you normally deal with in Rajah & Tann or the Knowledge Management team at eoasis@sg.rajahandtann.com Rajah & Tann Knowledge Management. All rights reserved. Page 6