Paul Hastings Newsletter for Investing & Operating in the People s Republic of China

CHINA MATTERS Paul Hastings Newsletter for Investing & Operating in the People s Republic of China August 2008 China s New Merger Notification Rules: What Does This Mean to International Investors? The State Council issued the Regulation on Notification Thresholds of Concentration of Undertakings (the Regulation ) on August 3, 2008. The Regulation, together with China s new Anti-Monopoly Law (August 2007) (the Anti- Monopoly Law ) that became effective on August 1, 2008, represent the beginning of a new era in China s merger control regime. Before August 1, 2008, China s merger control rules only apply to foreign parties cross-border acquisitions of Chinese businesses, and offshore acquisitions where the acquirer or the target has business activities in China, that would meet the notification thresholds under the Rules Regarding the Acquisition of Domestic Enterprises by Foreign Investors (August 2006) ( Circular 10 ). Once effective, the Anti-Monopoly law and the Regulation will supersede Articles 51 through 54 of Circular 10 and level the playing field between Chinese and foreign parties to mergers and acquisitions ( M&A ) by expanding the merger control regime to cover M&A activities between domestic companies as well. The legal Affairs Office of the State Council issued a draft of the Regulation (the Draft ) on March 27, 2008 to solicit public comments. The final Regulation eliminated definitions of several key terms such as control and decisive influence. It appears that the State Council is delegating interpretive authority to the newly created Anti-Monopoly Commission (the Commission ) to give the Commission room to form its own views on how to implement the law through case-by-case practical experience. We believe that the Ministry of Commerce ( MOFCOM ), which is now the sole anti-monopoly enforcement agency for concentration review, will also have significant interpretive authority. As such, we expect to see an interesting dialogue among the Commission, MOFCOM and the M&A community where the Commission and MOFCOM may offer guidance on interpretive issues through formal or informal expressions of views, and M&A practitioners may present their cases to the Commission and MOFCOM from a policy rather than technical compliance perspective, borrowing from regulatory experience in other more mature M&A markets around the world. To that end, we explore in this newsletter how the Regulation might affect three specific M&A and private equity investments situations, and how these situations are dealt with in the United States of America ( U.S. ) and the European Union ( EU ). The Paul Hastings global M&A team has also compiled Appendix I to this article, setting out selected comparisons among the pre-merger notification regimes (i) under the Anti- Monopoly law and the Regulation, (ii) under Circular 10, (iii) under the Hart-Scott-Rodino ( HSR ) rules in the U.S., and (iv) under the EU rules. Finally, we attach as Appendix II an English translation of the Regulation. Acquiring A Small Chinese Company Notification Requirement Not Triggered Any More? Foreign acquirers of small Chinese companies may be pleased to learn that compared with Circular 10, the Regulation has simplified the notification thresholds by dropping (i) the transaction volume test (i.e., acquired more than ten enterprises in the relevant industry within one year); (ii) the 20% pre-acquisition market share test; and (iii) the 25% post-acquisition market share test. The Draft kept the 25% post-acquisition market share test, but the final Regulation dropped this test after extensive public comment that it was difficult to quantify market share objectively, and that such test would deviate from prevalent international practice. 1 In addition, the two-party revenue test under the Regulation is widely applauded as improving efficiency when foreign acquirers acquire small or mid-size Chinese 18 Offices Worldwide Paul, Hastings, Janofsky & Walker llp www.paulhastings.com

companies. Under Circular 10, a notification would have been triggered if either the foreign acquirer or the target has revenue of more than RMB1.5 billion (US$219 million) because Circular 10 applied a single-party revenue test. Consequently, even a large-scale multinational company s acquisition of a small domestic company would trigger the notification requirement under Circular 10. By comparison, the Regulation takes into account at least (any) two of the parties revenues. Notification requirement is only triggered when the revenue of each of the two parties exceeds RMB400 million (US$58 million). European countries such as France, Spain, the Netherlands, Belgium and Croatia have adopted a similar test. That said, it remains unclear whether revenue of a party includes revenue of all of the party s affiliates within and outside China, particularly if the acquirer is a special purpose vehicle formed for a specific acquisition. Circular 10 requires a foreign investor s revenue and all of its affiliates revenue to be combined for the purpose of calculation, but Circular 10 does not define the term affiliate. The guidelines for notification issued by MOFCOM on March 8, 2007 (the MOFCOM Guidelines ) suggested that affiliate should include, with respect to any party, any other person that, directly or indirectly, controls, is controlled by, is under common control with such party, or is otherwise affiliated to such party. Interestingly, the way to calculate revenue under Circular 10 and the MOFCOM Guidelines has the similar effect as the Ultimate Parent Entity ( UPE ) approach under U.S. rules. The UPE is the single entity that controls those below it, but is not itself controlled by any other single entity. 2 Once the UPE is identified, revenue is calculated based on all entities controlled by that UPE. EU uses a similar approach under the EC Merger Control Regulation ( ECMR ), (i) revenue of the target would include that of all undertakings controlled by the target 3, and (ii) revenue of the acquirer equals the consolidated revenue of the group to which the acquirer belongs, in each case irrespective of where the revenue is generated. Acquiring A Minority Stake in China Notification Requirement Still Triggered? China: For an M&A or private equity transaction, a notification to MOFCOM is required when (i) the transaction constitutes concentration set forth under the Anti-Monopoly Law and the Regulation 4 ; and (ii) the transaction meets one of the notification thresholds under the Regulation. 5 To qualify as a concentration, the transaction must be: (i) a merger; (ii) an acquisition of control of another party through asset or equity acquisition; or (iii) possession of control of or decisive influence over another party by contracts or otherwise. The Draft had shed new light on two key terms - control and decisive influence. In terms of the definition of control, the Draft generally followed the customary interpretation (i.e., ownership majority or management control), except that, according to the Draft, control also exists when a party becomes the largest holder of the voting shares or assets of another party. The Draft also defined decisive influence as the ability to exert decisive influence over another party s decision-making on its production [and/or] operation. However, the Regulation does not define either of these terms. As such, it is unclear whether veto rights typically requested by a private equity investor would constitute decisive influence. If the answer is in the affirmative, typical minority shareholder protection rights may cause notification obligation to be triggered even if the investor only acquires a minority stake in a Chinese company. U.S.: By comparison, the HSR does not use the term decisive influence in a way that is separate and distinct from its definition of control. Protective measures taken by private equity investors, for example, that do not fall within the HSR definition of control (e.g., veto rights and management positions) do not themselves cause a transaction to be reportable. The U.S. does utilize the notion of decisive influence in other aspects of antitrust law and merger review, but not in the pre-merger notification context. That said, control is featured in three exemptions from pre-merger notification under the HSR rules: (i) acquisitions of voting securities of a non-u.s. issuer by another non- U.S. entity are exempt from notification unless the buyer acquires control of the target, (ii) acquisitions of non-corporate equity interests (e.g., limited liability companies, partnerships, etc.) are exempt unless the buyer acquires control of the target, and (iii) equity transactions resulting in a 10% or less stake in the target are exempt where the purpose of the transaction is for investment only. EU: The Anti-Monopoly Law and the Draft shared some similarity with the EU rules. The notion of control is one of fundamental concepts of EU merger control, and can be defined as the possibility of exercising decisive influence over an undertaking. Thus, control and decisive influence are synonymous under EU rules. A concentration occurs when there is acquisition of control, which can be accomplished through a variety of methods including acquisition of equity or assets, or simply through a contractual arrangement. 6 Acquisition of a minority stake is presumed not to result in a change of control. However, a minority shareholder may be deemed to have control (whether by itself or jointly with other minority shareholders) if it has legally pro-

vided or de facto veto rights over the most important strategic commercial decisions of the acquired party, such as (i) adoption of budget; (ii) adoption of business plan; (iii) right to appoint management; or (iv) right to approve the most significant investment decisions. Offshore Transactions When Does Notification Requirement Trigger? A plain reading of the Regulation does not reveal whether the notification thresholds would apply to M&A and private equity transactions outside China. One interpretation is that the China revenue elements in the notification thresholds establish the local nexus between an offshore transaction and the Chinese market; therefore, if an offshore transaction constitutes concentration and meets one of the thresholds set by the Regulation, notification in China is required. A more expansive interpretation would be even if none of the thresholds are met, as long as the transaction may have the effect of excluding or restricting competition in the Chinese market, notification is still required. Since notification rules in many jurisdictions do not distinguish between domestic or offshore transactions as long as notification thresholds are met, many apply extraterritorially to a certain extent (e.g., U.S., EU and Japan). The U.S. rules, however, contain several exemptions that apply specifically to offshore transactions. For example, an acquisition of voting securities of a non- U.S. issuer by another non-u.s. entity (unless the buyer acquires control) is one such exemption. In general, exemptions will also apply where the offshore target or its assets do not generate sales in or into the U.S. of US$63.1 million or more. Transactions between non-eu undertakings may be caught under EU merger control law, which focuses on the effects of undertakings activities on the EU market. As long as the notification thresholds are met, notification is required. Conclusion The Anti-Monopoly Law and the Regulation are a milestone for China s merger control regime by including domestic M&A under its regulation. To a certain extent, the thresholds for concentration notification have been simplified. Although relatively objective thresholds have been introduced to replace those under Circular 10, the regulators still have much discretion, particularly in light of the ambiguity of important legal concepts. How the Commission and MOFCOM exercise this discretion will be closely observed by the M&A and investment community in the coming months and years. Paul, Hastings, Janofsky & Walker LLP is licensed in the People s Republic of China as a foreign law firm permitted to advise clients on certain aspects of their international transactions and operations. Like all foreign law firms operating in China, we are not authorized to practice Chinese law. You are hereby advised that this document and prepared by us is based on our experience in advising clients on international business transactions and operations and on research and inquiries we deemed appropriate, and is not intended to be used (and cannot be used) as an opinion on the laws of China. To the extent you require such an opinion or the assistance of a qualified China lawyer, we would be pleased to assist you to identify an appropriate domestic China law firm. The author of this document does not hold a lawyer s license in the People s Republic of China. Paul Hastings is a limited liability partnership. Copyright 2008 Paul, Hastings, Janofsky & Walker LLP.

Appendix I: Major Differences among the Anti-Monopoly Law and the Regulation, Circular 10, and the Rules in the U.S. and EU Anti-Monopoly Law and The Regulation Circular 10 Hart-Scott-Rodino Rules EU Merger Control Regulation Scope of Application Concentration (a) Mergers; All M&As (whether domestic PRC or cross-border) (b) asset or equity acquisitions; or (c) acquisition of control of or decisive influence over another party by contract or otherwise Cross-border and only certain offshore M&A Certain defined asset or equity acquisitions All M&As (whether domestic U.S. or cross-border) (a) Mergers; (b) asset or voting securities acquisitions; or (c) joint venture transactions All M&As (whether domestic EU or cross-border) (a) Mergers; (b) acquisition of control (i.e. decisive influence) of another independent undertaking; or (c) creation of full-function joint ventures Notification Thresholds (a) Global revenues for all parties (exceeding RMB10 billion) plus China revenues for at least two parties (each exceeding RMB400 million) in the preceding fiscal year; or (b) China revenues for all parties (exceeding RMB2 billion) plus China revenues for at least two parties (each exceeding RMB400 million) in the preceding fiscal year (a) One party s China revenues exceed RMB1.5 billion in the current year; (b) Acquired more than ten enterprises in the relevant industry in one year; (c) Pre-acquisition market share in China reaches 20%; or (d) Post-acquisition market share in China reaches 25% (a) Either party is engaged in U.S. commerce or any activity affecting U.S. commerce; (b) Size of Transaction Test: value of what will be acquired (including securities and assets previously purchased from the seller by the buyer) is in excess of US$63.1 million; and (c) Size of Person Test: (i) global annual net sales or total assets of one party is US$126.2 million or more, and the other party is US$12.6 million or more, or (ii) the size of the transaction is greater than US$252.3 million 7 A concentration has a European Community ( Community ) dimension where: Test One: (a) the combined aggregate worldwide turnover of all parties is more than EUR5 billion; and (b) the aggregate Community-wide turnover of each of at least two of the parties is more than EUR250 million, unless each party achieves more than two-thirds of its aggregate Community-wide turnover within one and the same EU member state ( Member State ) Or, if Test One is not met, Test Two:

Anti-Monopoly Law and The Regulation Special Thresholds Methods to determine revenue for banking, insurance, securities, futures and other special industries to be Extraterritorial Application promulgated later Yes - if offshore merger activities have the effect of excluding or restricting competition in the Chinese Circular 10 Hart-Scott-Rodino Rules EU Merger Control Regulation (a) the combined aggregate worldwide turnover of all parties is more than EUR2.5 billion; (b) in each of at least three Member States, the combined aggregate turnover of all parties is more than EUR100 million; (c) in each of at least three Member States included for the purpose of point (b), the aggregate turnover of each of at least two of the parties is more than EUR25 million; and No No (but a variety of exemptions may apply depending on specifics of the transaction) (d) the aggregate Community-wide turnover of each of at least two of the parties is more than EUR100 million, unless each party achieves more than two-thirds of its aggregate Community-wide turnover within one and the same Member State 8 No Yes - if one of the five thresholds provided in the Circular is triggered (e.g., one party s China revenues exceed Yes - if the foregoing three threshold tests are met Yes - if any of the foregoing two threshold tests is met

Discretionary Investigation National Security Review Anti-Monopoly Law and The Regulation Circular 10 Hart-Scott-Rodino Rules EU Merger Control Regulation market RMB1.5 billion in the current year) Yes - enforcement agency may investigate even if notification thresholds are not met Yes - if a foreign party s acquisition of domestic enterprises (or otherwise participating in concentration) involves national security No Yes Yes (in addition to investigations that may be led by Member States) Notification to MOFCOM required if acquisition of control of a domestic party by a foreign party may affect national economic security Yes but governed by Exon-Florio provisions No

Appendix II: Regulation on Notification Thresholds of Concentration of Undertakings (Promulgated by the State Council on August 3, 2008 pursuant to its order No. 529) Article 1 The Regulation is hereby promulgated in accordance with the Anti-Monopoly Law of the People s Republic of China for the purpose of clarifying the notification thresholds of concentration of undertakings. Article 2 The concentration of undertakings refers to one of the following circumstances: (1) a merger between the undertakings; (2) acquisition of control of another undertaking through equity or asset acquisitions; (3) possession of control of or decisive influence on another undertaking by contract or other means. Article 3 Undertakings shall file with the authority in charge of commerce 9 under the State Council in advance where the concentration of the undertakings meets any of the following thresholds; otherwise the concentration may not be conducted: (1) the total global revenues of all undertakings to the concentration in the preceding fiscal year exceed RMB10 billion, and the China revenues of at least two of the undertakings each exceed RMB400 million in the preceding fiscal year; (2) the total China revenues of all undertakings to the concentration in the preceding fiscal year exceed RMB2 billion, and the China revenues of at least two of the undertakings each exceed RMB400 million in the preceding fiscal year. The calculation of revenues shall consider the practice of banking, insurance, securities, futures and other special industries and sectors, which specific rules shall be formulated by the authority in charge of commerce under the State Council together with relevant departments of the State Council. Article 4 Where a concentration of undertakings does not reach the thresholds set forth in Article 3 hereof, while facts and evidence collected through due process demonstrate that the concentration results in or might result in exclusion or restriction of competitions, the authority in charge of commerce under the State Council shall investigate in accordance with law. Article 5 This Regulation shall be implemented as of its promulgation date. NOTES: 1 According to the reports submitted by 58 members of International Competition Network (ICN) on their respective merger review systems, 16 out of 58 countries / regions use a market share standard, including the United Kingdom, Brazil, Spain, Russia, Australia, Singapore and Taiwan. 2 Under U.S. rules, control consists of 50% or more of the voting securities of another, or in the case of non-corporate entities, the right to 50% or more of the profits (or assets upon dissolution), or in either case the right to appoint 50% or more of the board. 3 Art. 5 (4), ECMR. 4 Article 2 of the Regulation repeats the definition of con centration under Article 20 of the Anti-Monopoly Law. 5 However, this might not apply if the transaction occurs outside of China. Please see discussions in the section of Offshore Transactions When Does Notification Requirement Trigger? 6 Art. 3(1)(b), ECMR. 7 Specific monetary levels are adjusted annually (usually in February). 8 If neither of the two thresholds is met, the merger must be assessed under the notification thresholds of the Member States. In addition, if notification is required in three or more Member States, the parties may apply for a combined, single EU-wide filing as opposed to file with each of the Member States. 9 Presumably, the authority in charge of commerce refers to MOFCOM. Paul, Hastings, Janofsky & Walker LLP is a global law firm with over 1, 200 lawyers in 18 offices in Asia, Europe and the United States. Paul Hastings has one of the largest, full service, multi-jurisdictional legal practices in Asia with over 210 legal professionals in Beijing, Hong Kong, Shanghai and Tokyo. For further information about this article, please contact: Beijing Huawei Lin: huaweilin@paulhastings.com Europe Pierre Kirch: pierrekirch@paulhastings.com Hong Kong Maurice Hoo: mauricehoo@paulhastings.com Shanghai David Wang: davidwang@paulhastings.com Yi Lu: yilu@paulhastings.com Tokyo Joy Fuyuno: joyfuyuno@paulhastings.com United States Hart Holden: jamesholden@paulhastings.com