A new approach for foreign investors to consider after Google

 

What can we learn from the case of Google?

 

This article will focus primarily on issues facing foreign investors wishing to participate in China’s mergers and acquisitions (M&A) market. However, the recent news relating to Google’s presence in China raises important points.  

 

We argue that the moral point of whether stronger levels of Internet censorship are correct is a separate issue. The key point is the need for those engaged in cross border activity to understand the Chinese regulatory system before a move is made and that once that move is made, an adjustment to the climate will be necessary. There is no suggestion that domestic search engines such as Baidu have received preferential treatment in comparison to others such as Google. If this were the case, then there would be a strong case for the authorities to change policy. Commercial operations in China should be divorced from political differences existing between the parties. The closer the two are intertwined, the more difficult it has proved to establish a lasting commercial relationship. 

 

Foreign participation in M&A – barriers to success

 

Imagine that a United States (US) football team travels to the United Kingdom (UK) expecting to play football. On arrival, the US team is fully prepared but realises that the form of football played in the United Kingdom is not the same as that played in the United States. The sports have the same name but the rules are different.

 

Foreign investors seeking an M&A deal involving a Chinese company should bear this analogy in mind. The Chinese M&A legal and regulatory structure is based on a social and economic system that is different from those in the United States and Europe. It is not a fully developed free market economy and in the sphere of investment, regulators are often as concerned with the substance of an arrangement and its consequences as compliance with the technicalities. Investors sometimes fail to appreciate these points.

 

Partly as a response to the Google situation, and other cases observed involving cross border activity with China, thought has been given as to what can be done to improve the likelihood of a successful entry into the Chinese market and the maintenance of such a position.

 

A New Model for Investors

 

A new approach for managers and potential investors interested in China’s M&A market is required. This approach consists of:

 

1.         The importance of dialogue – particularly with Chinese supervisory authorities such as MOFCOM (the Chinese Ministry of Commerce) and potential Chinese partners;  

2.         The recognition that the Chinese M&A regulatory regime is distinct and that there are social, economic and political explanations for this;

3.         The recognition that following Chinese law in an M&A deal and after completion in a constructive fashion will increase the likelihood of a successful investment;

4.         The need for investors to approach each transaction in a balanced way including a focus on the specific investment opportunity in hand as well as an understanding of broader economic and regulatory trends;

5.         A recognition that although similar terminology is now being used in Chinese laws and regulation, such as the Anti Monopoly Law of 2008, such terminology often has a different meaning in the Chinese context from that expected in the West;

6.         An appreciation that at a number of stages in M&A deals in China, there will be a range of regulatory authorities interested with specific concerns to be addressed; and

7.         An understanding that regulations are tested at local and regional levels before implementation nationally. This is particularly the case with private equity regulations which have been developed in Chinese localities. Knowledge of the nature of the regime in the specific place of planned investment is important.

   

The points above highlight the important issue of investor philosophy. The analysis below will look at a number of specific examples demonstrating how the new approach will be of use to investors.

 

Purchase price and consideration issues – an example of how the parameters for negotiation in China are defined

 

A fundamental part of the investment process is to structure payment of the consideration for the shares. In Chinese contract formation, and this includes share purchase or transfer agreements, there are certain areas that are prescribed by domestic regulation.

 

In the context of foreign investors acquiring shares in Chinese companies, the 2009 Regulation Provisions on M&A of a Domestic Enterprise by Foreign Investors sets important rules. Depending on the percentage of the shares of the company acquired, the regulation sets different time limits by which stage the purchase price must be paid. For example, if less than 25% of the shares in the target are purchased, the limit is three months if the consideration is cash. Above this level, the basic requirement is three months but this can be extended in certain circumstances.

 

A 2008 regulation promulgated by the State Administration of Foreign Exchange, known as ‘Circular 142’, requires that foreign investors in settling the consideration must pay it into a special foreign exchange account with the approval of the Administration of Foreign Exchange. There are other documentary requirements to be complied with by the seller including the need for a document certifying the purposes of the Chinese Reminbi obtained.

 

Some argue that these measures are too restrictive. Applying the model above, if the contexts behind the measures are investigated, investors will find strong policy reasons behind them. One is the need to create certainty for the parties. There is a concern to protect sellers, a substantial proportion of which are Chinese citizens or companies. Another factor is the problem of ‘hot money’. Contracts in Chinese law are subject to strict legal requirements.  

 

Like markets in other countries, a number of stakeholders are interested in China’s M&A market – take the example of antitrust/competition regulation

 

Antitrust or competition concerns can arise from a merger or acquisition itself or from how a target once acquired, behaves. Authorities have the jurisdiction to make investigations in relation to a range of antitrust issues as prescribed by China’s new Anti-Monopoly Law (AML) and a range of other regulations comprising China’s antitrust/competition regime. China’s Ministry of Commerce (MOFCOM) is given the responsibility of merger review and conducting investigation into possible effects on competition pursuant to the Provisions on the Mergers and Acquisitions of Domestic Enterprises by Foreign Investors as amended. The National Anti-Monopoly Commission has been established with the aim of overseeing the process of review.  

 

In certain circumstances, government bodies can become involved in competition or antitrust investigations in relation to the behaviour of a target once it has been acquired. The State Administration for Industry and Commerce (SAIC) enforces aspects of competition law under the 1993 Anti-Unfair Competition Law, and abuses of a ‘dominant position’ as described in the AML. The National Development and Reform Commission (NDRC) oversees the regulation of prices as set out under the Price Law of 1997. This encompasses so called ‘predatory pricing’ and other forms of pricing discrimination, aimed at undermining competitors.  

 

Hypothetically, an acquired target could abuse a dominant position, thus attracting SAIC’s attention and also implement ‘predatory pricing’ tactics as envisaged by the 1997 Price Law, giving the NDRC power to investigate as well. Some have argued that this overlap will create uncertainty and lead to inconsistent results. However, is the Chinese system alone in creating such concerns for investors?

 

It can be argued that the antitrust/competition systems in the West, like China, have a range of bodies with different responsibilities for oversight. In the United Kingdom, the Office of Fair Trading (OFT) has jurisdiction to look at anti-competitive behaviour, including the potential effect of a merger or acquisition. In the context of a merger or acquisition, the OFT can refer the case to the UK’s Competition Commission (CC) if conditions are met. Furthermore, in certain circumstances involving a merger or acquisition, the European Commission will have jurisdiction to review it instead of the UK authorities. A task of a competition lawyer in this situation is to analyse which body has jurisdiction.

 

Other regulators in the UK have responsibilities for observing conduct in specific market areas such as communications (Ofcom), gas and electricity (Ofgem) and water (Ofwat). Some in the UK have argued that there is the potential for these regulators to overlap with the OFT in terms of their activity and remit.  

 

Therefore, the idea of overlap in parts of the antitrust/competition regime, and the associated worry of inconsistency, are found in other jurisdictions as well as the Chinese one and parts of the UK system provide an example.

 

The Chinese approach to regulation – how Private Equity is developing

 

The participation of private equity funds in M&A deals in China is an important issue and its development provides an example in microcosm of how the various regulators adopt a cautious approach. Tentative steps have been made to open up the Chinese market to foreigners.

 

In Beijing, the Interim Measures on Foreign-Invested Equity Investment Fund Management Enterprises came into effect on 1 January 2010. This regulation enabled foreign private equity institutions to have a presence in the region by way of a joint venture, partnership or wholly foreign owned enterprise. This measure provides investors with more flexibility and the availability of the partnership option has been welcomed. Private equity firm the Carlyle Group has agreed to work with the Beijing Municipal Government in establishing an RMB – denominated fund.

 

Beijing has followed the example of Shanghai. In July 2009, Shanghai Pudong New Area’s People’s Government promulgated the Pilot Measures for the Establishment of Foreign-Invested Equity Investment Management Enterprises in the Pudong New Area of Shanghai. This regulation provided a number of structures through which private equity funds could be used to conduct M&A activity. The Blackstone Group has agreed a joint venture with the Shanghai Municipal Government in forming an RMB fund and in late February 2010, the Carlyle Group announced the formation of another private equity fund in China with Fosun International.

 

What is the situation in relation to China’s national regulation on this issue? The Measures on Establishment of Partnership Enterprises by Foreign Enterprises and Foreign Individuals promulgated by the State Council became effective as of 1 March 2010. The Measures open up the use of the partnership, a favoured vehicle for investors, to foreigners. However, the measure is silent on whether or not such a partnership could be used to carry out private equity investment activity. There was an expectation that the measure would be similar to the Beijing Interim Measures mentioned above. However, we will have to wait and see how the measure is interpreted.

 

This is a further sign of how the Chinese system operates. The government is content to test innovation at a local level before implementing it on a broader scale. Variation in the legal situation from area to area shows the importance of context.

 

Make sure you take the right approach to conducting M&A in China

 

The range of policies, ambitions and concerns advocated by a variety of bodies explains the character of the Chinese system. For example, there is a need to provide liquidity but also control inflation, an aim to promote private enterprise but also protect the position of the Chinese consumer. Further, there are the broader structural concerns such as the promotion of urbanisation, employment and growth. Then there is the balance to be struck on how to engineer growth – through promoting the Chinese State Owned Enterprises or through businesses in private hands? How can the capital markets be regulated to play a part in this? All of these form part of the policy landscape. The points identified underline the need for managers of companies seeking M&A activity in China to build up dialogues and contacts in order to gauge a better understanding of the regulatory environment. The new investor model for engagement outlined above is designed to help achieve this. If management is divorced from the reality of the M&A environment, this only increases the scope for problems later.  

 

本文刊载于《资本交易》杂志  Published on 《The China Dealmaker》