Certain Recent Entrepreneurial Responses to China’s Mergers &Acquisitions RulesArticle Contributed by:Simon Luk, Winston & Strawn LLPUntil the arrival of the worldwide financial crisis in late 2008, private equity in the People’s Republic of China (PRC) grew tremendously in recent years. The growth was spurred by offshore funds seeking to take advantage of the entrepreneurial talents of the private Chinese business community and Chinese entrepreneurs who wished to access foreign capital markets and re-invest in China under the more favorable guise of a foreign entity.The PRC regulatory authorities, including the Ministry of Commerce (MOFCOM) and the State Administration of Foreign Exchange (SAFE) became concerned about the loss of tax revenue, control of sensitive assets by offshore persons, and the redomiciling of assets, and decided to tighten regulatory controls on PRC entrepreneurs, and the venture capital and private equity community. Consequently, the PRC government issued stricter regulations imposing approval requirements on foreign investments, including the Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors (关于外国投资者并购境内企业的规定)1, generally known as the PRC M&A Rules (the Rules) and several related regulations and guidelines.As a result, the once-prevalent “round trip” investment, which involved an offshore company owning a domestic business on mainland China, was largely curtailed. Chinese entrepreneurs and their advisors, in turn, responded to this increased regulatory oversight by employing certain investment vehicles aimed at avoiding the harsher effects of the new government rules, including structures popularly known as the “slow walk” arrangement and the “variable interest entity.” Both structures have triggered some debate among Chinese lawyers2 and entail some degree of risk for those who have resorted to them, as the following analysis will articulate.The 2006 PRC M&A RulesIt has been more than two years since MOFCOM, along with five other ministries—the State-owned Assets Supervision and Administration Commission of the State Council, State Administration of Taxation, State Administration for Industry and Commerce, China Securities Regulatory Commission, and SAFE—jointly issued the Rules. The Rules became effective on 8 September 2006. In brief, the Rules provide that if a Chinese domestic company merges with an offshore company established by the Chinese resident who controls such domestic company before the merger, an application must be made to MOFCOM for approval.One of the principal reasons for the implementation of the Rules was in response to the use of round-trip investment structures used by Chinese domestic businesses to take advantage of tax and other incentives that the PRC government has granted to non-Chinese businesses to stimulate foreign investment. In a round-trip investment structure, a Chinese entrepreneur would acquire his own domestic assets or businesses through a special purpose vehicle incorporated outside of China. By incorporating an offshore company and structuring it to own a Chinese domestic business, the Chinese entrepreneur could turn domestic assets and businesses into foreign-owned assets and businesses, entitling the entrepreneur to tax benefits available only to foreign investors. Although tax benefits were less of a motivating factor with the unification of the domestic and foreign tax law regimes, an important advantage of round-trip investment for Chinese entrepreneurs was that any subsequent change of ownership of an offshore holding company would no longer be subject to the approval of the Chinese authorities. Therefore, an offshore holding structure or “red-chip redomicile” provided more flexibility for Chinese entrepreneurs looking to attract foreign investment, since Chinese regulatory approval would not be necessary before an investment in, or purchase of, an offshore holding company. Foreign investors are generally more comfortable with investing in an offshore company incorporated in a tax haven because of the safety and flexibility such jurisdictions offer.© Bloomberg Finance L.P. 2009. Originally published by Bloomberg Finance L.P. Reprinted by permission.The Rules expressly require that parties to a merger or acquisition transaction involving Chinese companies and assets specify if the parties are associated with each other. If there are two parties that have the same de facto controller, the relevant parties must disclose the identity of the de facto controller to the approving authority and specify (1) the purposes of the transaction; and (2) whether the relevant valuation of the subject matter of the transaction represents a fair market value. The parties are prohibited to avoid this requirement by way of trust, nominee holding or other method. Since the enactment of the Rules, round-trip investment activities have been significantly curbed due to the difficulty in obtaining approvals. Accordingly, Chinese entrepreneurs and foreign investors have responded in a number of ingenious ways.Market Responses to the RulesIn response to the Rules, some Chinese and foreign market participants have devised new transactional structures aimed at avoiding the reporting requirements. Of particular interest are the “slow walk” arrangement (SWA) and the variable interest entity structure (VIE structure).“Slow Walk” Arrangement: Under a SWA, the owner of a PRC domestic business converts the domestic business to a foreign invested enterprise, usually a wholly foreign-owned enterprise, by selling the business to a special purpose vehicle owned by a third party. The special purpose vehicle is usually established in the British Virgin Islands or in Hong Kong. See Diagram I.Diagram IThe original owner (OO) is invariably the chief executive officer and chairman of a Chinese domestic enterprise before the sale to the special purpose vehicle. Because the OO is deemed key to the business, it is essential for the third party or the new owner to retain the service of the OO for the continued development of the business. As such, the new owner will enter into an earn-in agreement with the OO. Under the earn-in agreement, the new owner will, subject to satisfaction of certain conditions, grant a call option to the OO to purchase a controlling interest, usually over 50 percent, in the special purpose vehicle or its holding company which holds the original domestic business, over a period of time and in stages. The exercise price of the option is generally low, and very often the same as the par value of the shares.The conditions under which the call option may be exercised are usually linked to the entry of a binding employment agreement by the OO and/or attainment of certain profit levels by the group. In general, complying with the conditions will not be difficult. The option will have an exercise period similar to the term of the employment agreement with the OO. Such period may extend to as long as five years. Over such prolonged period, the OO will exercise the call option to require the new owner to gradually transfer the ownership of the business back to the OO. This is where the name “slow walk arrangement” originates. To secure the interest of the OO, the shares subject to the call option may be placed with a custodian upon signing of the earn-in agreement. This arrangement is structured as an incentive program for the key personnel. Therefore, in the application to the relevant Chinese authority to convert the domestic Chinese enterprise to a foreign invested enterprise, the OO is not regarded as being associated with the acquisition of the special purpose vehicle or the new owner. Some Chinese lawyers have taken the position that this arrangement will not be classified as a round-trip investment.It appears that no transaction adopting the SWA structure has ever been submitted to the Chinese authorities for clearance and no guidelines or rulings in respect of the SWA have been issued. Hence, the SWA does not seem to have been tested with the Chinese authorities. Because the Rules are worded very broadly and generally, the SWA may be deemed by MOFCOM as an arrangement made to avoid the application of the Rules.Besides the regulatory risk, the SWA is not hassle-free. With the controlling interest of the business held by a third party for a prolonged period, there is no guarantee that there will not be any disputes between the new owner and the OO over the direction, timing and valuation of fund raising exercises involving the business. As an example, the new owner’s compensation for participating in the SWA may be tied to a successful going public transaction, often accomplished via a reverse takeover of a listed shell company in the US over-the counter market. Particularly in light of the continuing financial crisis, the new owner may be motivated to complete a reverse takeover at the current low valuation over the objections of the OO, who would want to wait for a higher valuation. Disputes and lawsuits over the legality of the SWA may result. This may also pose potential management instability, which endangers the development of the business. The SWA has been described in SEC filings for a number of Chinese businesses that have raised funds outside China.Variable Interest Entity Structure: The VIE structure was in use even before the Rules became effective. It has been and still is widely used in businesses involving internet portals and other media related media in China, which prohibits direct ownership of such businesses by foreigners. Examples include Sina Corporation, Baidu, Inc. and Inc. See Diagram II.Diagram IIUnder a VIE structure, a domestic Chinese business is controlled, through various contractual arrangements, by a special purpose vehicle or an offshore entity. The OO of the domestic Chinese business becomes the beneficial owner by forming an offshore special purpose vehicle and simultaneously entering into a sale and purchase agreement with a Chinese resident for the sale of the domestic Chinese business. The Chinese resident would then sell the interest in the domestic Chinese enterprise to an independent third party, who must be a Chinese resident and would then become the legal owner. At the same time, the OO will enter into various contractual arrangements with the legal owner, which will normally include a technical service or support agreement to pay all or nearly all of the profits of the domestic Chinese enterprise in the form of service or support fees to the special purposes vehicle. As security for this arrangement, a loan agreement, share pledge and an option agreement will be prepared and executed. Under the loan agreement, the OO will advance to the legal owner sufficient funds to acquire the domestic enterprise from the OO. In return the legal owner will pledge the equity interest of the domestic Chinese enterprise in favor of the OO. The legal owner will also grant an option to the OO or its offshore vehicle to acquire the interest in the domestic Chinese enterprise. Under the contractual arrangements, the offshore entity will have all or nearly all of the profits and de facto control over the domestic Chinese enterprise for the benefit of the shareholders of the special purpose vehicle, which will include institutional investors.There is no need to make an application to MOFCOM for approval because a VIE structure only involves a transfer of the shares in a domestic Chinese enterprise between Chinese residents and there is no round-trip investment. The issue of round-trip investment is thereby avoided, at least formally. As with the SWA, there is no certainty that the VIE structure comports with the Rules. Also, the VIE structure suffers from the inability to transfer the assets and liabilities of the Chinese domestic enterprise to the special purpose vehicle, which will make listing in a foreign market difficult if not impossible. Finally, under international and U.S. generally accepted accounting principles, profits of the domestic Chinese enterprise are not included in profits of the special purpose vehicle unless the special purpose vehicle can demonstrate that it controls the Chinese enterprise through management or otherwise3.Despite these drawbacks, the VIE structure has been used in a number of recent fund raisings for expansion capital by Chinese companies seeking a listing or already listed in the U.S. The responses from institutional investors were encouraging until the arrival of the recent financialcrisis. The VIE structure has been used by Chinese companies engaged in all industries, including software, traditional industrial manufacturing, and natural resources mining.The Chinese government is keeping a close eye on the development of its economy, especially in the aftermath of the global financial crisis, to maintain a strict control regime. The Rules are an indication of its determination to assert control over what they regard as domestic Chinese assets. The Chinese government may impose tighter control over M&A activities involving Chinese entrepreneurs in order to preserve stability in both its foreign exchange policy and national capital account. Investors investing or planning to invest in structures similar to the ones described above should take into account the regulatory risks involved.Simon Luk, a partner in the firm’s Hong Kong office, is chairman of Winston & Strawn’s Asia practice. His practice focuses on international corporate securities. Mr. Luk represents multinational corporations in cross-border mergers and acquisitions, U.S. capital market fund raising, compliance with regulations of the Securities and Exchange Commission, and the acquisition of assets and brand names. Mr. Luk serves as honorary legal adviser to the Chamber of Listed Hong Kong Companies, the Hong Kong Electronics Association, the Toy Manufacturers Association of Hong Kong, the Hong Kong Electrical Appliances Manufacturers Association, the Hong Kong Young Industrialists Council, the Monte Jade Science and Technology Association of Hong Kong, the Hong Kong Brands Protection Alliance, and the Hong Kong Shandong Business Association.Email:****************.The views expressed herein are the author’s own and do not represent those of Bloomberg Finance L.P.1AvailableinSimplifiedChinese.See,forexample:/fortune/2006-08/10/content_4944032.htm.2There is no unified view as to the viability of such methods. For example, in his book titled “Venture Capital & Private Equity in China” (2008) published by Law Press China, Joseph Chan said on page 809 that “[a] literal reading of the definition of “mergers and acquisitions” under the [Rules] would appear to exclude from its scope of application certain contractual relationships that are commonly seen in venture investments in the restricted or prohibited sectors in China. Such contractual relationships are often referred to as the “Sina model” contracts…While there is no consensus yet on the applicability of the M&A Regulations to the Sina model contracts among industry players…It is unclear whether MOFCOM will broaden the scope of the M&A Regulations to cover the varied forms of the Sina model contracts.”3“Consolidation of Variable Interest Entities” - Financial Accounting Standards Board Interpretation No. 46R.。
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