Copyright Euromoney Institutional Investor PLC Oct 2006

China's latest merger and acquisition (M&A) rules have already generated much concern among foreign investors desiring to acquire Domestic Companies. The regulations come at a time when several high profile and controversial M&A deals hang in the balance. Will the new rules create new obstacles for foreign-funded M&As or will they provide better procedures for acquiring domestic enterprises?

By Peter A. Neumann and Tony Zhang*, Faegre & Benson, Shanghai

During the past 12 months until June 30 2006, over 250 Chinese enterprises worth more than US$14 billion have been acquired by foreign purchasers. 1 China's regulatory structure for foreign-funded mergers and acquisitions (M&A) is struggling to keep up with the emerging market for cross-border corporate control. The Provisions on Acquisitions of Domestic Enterprises by Foreign Investors (New Provisions) issued by six central government authorities 2 on August 8 2006 became effective on September 8, replacing the Tentative Provisions on Acquisitions of Domestic Enterprises by Foreign Investors 3 (Tentative Provisions), which have been in force since April 12 2003.

The New Provisions reflect fundamental underlying concerns that foreign interests are acquiring capacity and market share in China, without adequate oversight by the central government and the need to control the influx of'hot' money speculating on reminbi-denominated assets. Other key concerns involve shifting ownership of business assets offshore for less than fair value and the illicit overseas'round-tripping' of China-sourced investment to take advantage of foreign investment incentives.

Well articulated, published regulations that clarify the government's role in M&A are generally welcome. It remains to be seen whether the New Provisions will, on balance, provide greater certainty and lower the perceived risk of investing in China, or prove to be a deterrent to M&A activity that would be beneficial to China's development and specific underperforming industries. The answer to this question will likely depend on the issuance of detailed implementing rules essential to even-handed and transparent application of the New Provisions.

Legislative developments

Tentative provisions

The Tentative Provisions were issued somewhat hastily by the Ministry of Foreign Trade & Economic Cooperation, shortly before the ministerial restructuring that produced the Ministry of Commerce (MOFCOM). 4 The Tentative Provisions served to put foreign investors on notice that previously unregulated acquisitions of assets of privately-owned, non-listed Chinese companies would be subject to substantive government scrutiny. Moreover, in an apparent effort to emulate the practice in many Organization for Economic Co-operation and Development (OECD) countries, pending passage of the PRC Anti-monopoly Law, the Tentative Provisions imposed new procedures for anti-monopoly filings and set trigger thresholds for mandatory filings (Article 19-Article 22 of the Tentative Provisions).

The New Provisions continue, in effect, many of the basic rules found in the Tentative Provisions, but add considerable content on subjects such as the roles of various government agencies, reorganization of Chinese enterprises under offshore special purpose vehicles (SPVs) and various provisions designed to address'round trip' investments, whereby PRC domestically-owned firms seek to secure preferential treatment normally reserved for foreign invested enterprises (FIEs). It is worthwhile to note that the New Provisions were issued shortly after other regulations, which appear to give a green light to more aggressive foreign strategic investment in listed companies, and even outright takeover of listed companies, by foreign investors. 5

Regulatory developments in M&As

The year 2006 has so far seen some important legislative and regulatory developments helping to lay the foundation for an orderly market for corporate control in China. Prominent among these are the extensively revised PRC Company Law, amended PRC Securities Law and certain new regulations both on foreign investment and domestic M&A activities, such as the Measures for the Administration of Strategic Investment in Listed Companies by Foreign Investors 6 and the Acquisition of Listed Companies Administrative Procedures (Takeover Code). The New Provisions, however, will have the greatest immediate impact on foreign investors desiring to acquire Chinese companies.

In replacing the Tentative Provisions, the New Provisions provide a more transparent and tightly controlled system of M&A administration in which MOFCOM has ultimate approval authority over many transactions. However, prior approvals may be required from other state agencies such as the China Securities Regulatory Commission (CSRC), the State Asset Supervision and Administration Committee of the State Council (SASAC) 7 and the National Development and Reform Committee (NDRC) 8 under related regulations if a given acquisition involves listed companies, state-owned companies or large-scale foreign investment projects.

Recent heated debate, a regulatory response?

The acquisition of domestic enterprises by foreign investors has become a popular and controversial topic among Chinese officials, scholars and entrepreneurs in recent years. Two significant acquisitions of major Chinese state-owned companies have been stalled, pending governmental approval and one acquisition of a prominent private company has been publicly opposed by six domestic competitors (see Table 1, Pending Acquisitions). Moreover, the Chinese business press has reported that the NDRC may issue a list of industries and enterprises that are off-limits to foreign acquisitions some time in 2006. 9

The three pending acquisitions (listed in Table 1) face different obstacles but have all attracted much public attention and scrutiny by domestic competitors. The final decisions rendered by MOFCOM or the State Council, as applicable, as well as the proposed NDRC list and anticipated implementing rules, will provide crucial guidance on the policies, which will guide application of the New Provisions to future acquisitions.

Mixed policy agenda

The New Provisions aim to implement multiple policy goals that converge in the M&A context. They attempt to counter the shift of PRC domestically-owned assets to offshore ownership for less than fair value, followed by the realization of the expatriated value through offshore securities listings and trade sales, as well as'round-tripping' of PRC domestic funds to obtain foreign investment-related tax reductions and customs exemptions. These goals certainly appear to reflect legitimate concerns, particularly if the subject PRC assets were once improperly converted from state to private ownership. Nonetheless, the various additional governmental approval requirements and the delays involved, may have a chilling effect on many legitimate transactions that help sustain foreign direct investment (FDI) flows that might otherwise slow as increasing costs and renminbi appreciation make China less attractive for traditional direct investments. Perhaps more fundamentally, the New Provisions could deter M&A activity essential to improving the efficiency of industries with over-capacity and out-dated technology.

Anti-monopoly filing and review procedures, if objectively applied, serve to uphold fair competition, but vaguely worded protections for "national economic security" are readily subject to abuse unless public, objective standards are fairly applied. Moreover, the fact that only the foreign-invested sector is subject to malleable, opaque rules, prior to enactment of a universally applicable anti-monopoly law is inherently unfair and protectionist, as it permits business concentrations by Domestic Companies to the exclusion of foreign and foreign-invested companies.

The recurring theme of protecting Chinese culture is apparent in disclosure requirements relating to acquisitions involving'famous' or legacy Chinese brands. Underlying all of these considerations, however, is a desire to pull significant approval powers back to the central government, manifesting continuing tension between the central authorities on the one hand, and provincial and local authorities on the other.

Scope of coverage: too narrow or too broad?

Particularly in view of the additional required approval submissions, there is the potential for burdensome central government approval procedures and antitrust review. Accordingly, the actual scope of coverage of the New Provisions warrants close scrutiny. A close examination of Article 2 and Article 55 suggests that coverage is, perhaps arbitrarily, either too narrow or too broad.

Transactions clearly covered

Article 2 defines the term 'Share M&A' to mean foreign investors' purchase of non-FIE domestic enterprises by acquiring the shares of the target, or subscribing a capital increase in the target, and converting the target into an FIE. Significantly, the New Provisions define non-FIE domestic enterprises as 'Domestic Companies'.

The article also defines the term 'Asset M&A' to mean transactions involving both the establishment by a foreign investor of an FIE and use of that FIE to acquire and operate the assets of a domestic enterprise, or the purchase by a foreign investor of a domestic enterprise's assets and use of those assets to establish an FIE that operates those assets. It worthwhile to note that'domestic enterprise' is stated generically and is not a defined term. Pursuant to Article 55, M&A of'domestic enterprises' by FIE investment companies are also governed by the New Provisions.

Transactions arguably covered

Although the general perception is that the New Provisions chiefly aim to regulate the acquisition of companies that are not foreign-owned, the formulation of Article 2 and Article 55 strongly suggest that Asset M&A involving FIE targets also falls within the scope of the New Provisions. This is because Asset M&A encompasses targets that are domestic enterprises (as opposed to Domestic Companies), which fairly include FIEs. Similarly, Article 55 appears by default to leave acquisitions of assets of one pre-existing FIE by another pre-existing FIE within the scope of the New Provisions. 12

Transactions arguably not covered

Article 55 states fairly clearly that acquisitions of'domestic enterprises' by existing FIEs are to be governed by regulations applicable respectively to the merger and splitting of FIEs, and domestic investment by FIEs. 13 Since the latter regulations encompass acquisition of Domestic Companies by FIEs, 14 they preempt the New Provisions in this case.

Observations

It is somewhat puzzling that some M&A transactions by existing FIEs are covered and some are not. If the drafters of Tentative Provisions and the New Provisions were truly concerned about excessive and anti-competitive business concentration, they would have considered a clearer and broader scope of application. At the same time, assuming anti-monopoly regulation is best left to the future issuance of the anti-monopoly law, there is no compelling reason why Asset M&A between FIEs should be within the ambit of the New Provisions.

Key features of the New Provisions

Compared to the 2003 Tentative Provisions, the New Provisions provide a more comprehensive regulatory framework for M&A by foreign investors. A comparison of the main contents of the Tentative Provisions and the New Provisions is provided in Table 2. An overview of the significant additions and clarifications found in the New Provisions will be discussed in the following sections.

Qualification for FIE treatment: substance over form

The basic requirement that at least 25% of the post-acquisition target's registered capital must be owned by the foreign investor in order to qualify for FIE incentives continues to apply. However, the New Provisions look beyond the investor of record to the beneficial owner for purposes of making this determination. If the new enterprise is established by acquisition of a domestic target by an overseas purchaser, and that purchaser is controlled or set up by a domestic PRC company, enterprise or person that is affiliated with the target, then such related-party investment will be disregarded for purposes of qualifying for FIE status. Nonetheless, if the acquisition involves increasing by at least 25% of the target's registered capital, the target will be treated as an FIE after the acquisition. In any event, such related-party acquisitions must be directly submitted to MOFCOM for approval (Article 11).

Chinese brands and economic security

According to Article 12 of the New Provisions, both foreign investors and domestic enterprises are required to report the details of the acquisition to MOFCOM if the acquisition:

i. involves Chinese'key industries';

ii. includes factors that influence or might influence State economic security, or

iii. may lead to transfer of control of domestic enterprises that own 'famous China trademarks' ([Chinese characters omitted]) or 'old China trade names' ([Chinese characters omitted]).

The penalties for failure to comply with this reporting requirement are potentially draconian, as MOFCOM may require that the deal be aborted or that the subject equity or assets be transferred to Chinese parties, or take other measures as required (Article 2 para.2).

Additional documents required by MOFCOM

Under Article 21 and Article 23 of the New Provisions, the following additional application documents are required for MOFCOM approval:

i. agreement for resolution of the debts and creditors' rights of the domestic enterprise (if concluded, in the case of an asset purchase);

ii. appraisal report of the equity and assets to be transferred, and

iii. explanation of the relation among parties to the acquisition. 15

Shortened contribution schedule for new FIEs

While the basic three-month time limitation for payment of acquisition consideration remains, the New Provisions impose a shorter schedule on acquisitions effected by capital increase of the target. In such cases, the foreign investor must pay not less than 20% of the capital increase when the target applies for a new FIE business licence. Other registered capital contributions remain subject to laws and regulations governing foreign investment. The consideration for asset acquisitions by foreign purchasers must also be paid within three months (Article 16, para.2).

Foreign exchange registration

Another new requirement involves the issuance of a foreign investment related foreign exchange registration certificate for receipt of foreign exchange from share transfer ([Chinese characters omitted]) pursuant to Share M&A. The relevant foreign investment approval authorities will forward the approval for purchasing shares of a domestic target by foreign purchasers to the local SAFE branch. Once the foreign purchaser pays the consideration to the target's shareholders, the local SAFE branch will issue the Certificate to the target. The Certificate serves as'valid' evidence that the foreign investor has paid the consideration for the targets' shares (Article 25).

Share swaps by foreign purchasers

A welcome development of the New Provisions is found in Part Four (use of equity as the method of payment in the acquisition of a domestic company by a foreign investor), which contains detailed regulations governing share swaps between foreign purchasers or SPVs and the shareholders of the domestic target. An acquisition paid with foreign-listed shares is only permitted, however, in the case of Share M&A deals.

Qualifications of purchaser

Pursuant to Section 1 of Part Four, a foreign company intending to use its shares as acquisition currency must:

i. be legally incorporated in a foreign jurisdiction with a well-developed system of corporate law;

ii. not have been (nor its management team) subject to sanctions by the relevant authorities in the previous three years, and

iii. be publicly-listed under a mature stock transaction system (note that SPVs are exempted).

Qualifications of shares

A foreign purchaser's shares to be used as acquisition consideration must:

i. be lawfully held by shareholders and freely transferable;

ii. have no disputes regarding ownership, have not been pledged or subject to any third-party rights;

iii. be listed on an overseas public stock exchange (but not an over-the-counter market), and

iv. have a transaction price that is'stable' during the previous year.

Note that items (iii) and (iv) are not applicable to SPVs.

M&A consultant for Domestic Companies

According to Article 30 of the New Provisions, the shareholders of a domestic target contemplating a share swap must hire an intermediary registered in China (M&A Consultant). The M&A Consultant must, among other things, conduct verification of application documents, the foreign company's financial condition and the compliance status of the acquisition, and issue a report containing its specialist opinion on the acquisition (Articles 14,

28-30).

Applications

In addition to the basic documentary requirements, if the acquisition is by means of a share swap, the domestic target is required to submit the following documents when applying for MOFCOM approval (Article 32):

i. an explanation of equity changes and major asset changes of the target in the past year;

ii. the M&A Consultant's report;

iii. the incorporation certificate and identification of both domestic target and foreign purchaser and their shareholders;

iv. an explanation of shareholdings in the purchaser and a list of shareholders holding over 5% of shares in the overseas company;

v. the foreign purchaser's articles of association and explanation of'external' guarantees, and

vi. audited financial statements of the foreign purchaser for the previous year and a report of the share transactions situation in the previous six months.

Approval certificates

MOFCOM will issue a certificate approving the establishment of a foreign invested company if it approves the acquisition application, but bearing a legend ("cents) on the certificate that the approval is "valid for six months from the date of issuance of the business licence". The target is also required also to apply for a new business licence and foreign exchange registration certificate bearing the notation "valid for eight months from the date of issuance". The target must submit the legended business licence to MOFCOM for verification and registration of outbound investment. 16 After verifying that the target's shareholders have received shares of the purchaser, MOFCOM will issue the approval for outbound investment to the target and exchange the legended approval certificate for a clean approval certificate (Articles 33-35).

The legended approval certificate for equity acquisition and the approval of outbound investment for the target will be voided, if either the foreign purchaser or domestic target fails to complete procedures for modifying their shareholding structure within six months from the issuance date of the inscribed business licence (Article 37).

Special purpose vehicles

SPVs, the offshore holding companies for overseas initial public offerings (IPOs), were previously addressed in the Circular on Relevant Issues of the Foreign Exchange Administration for Overseas Financing and Round-Trip Investment by Domestic Residents Through Offshore Special Purpose Vehicles (commonly known as 'Circular 75'), an important notice issued by SAFE, in 2005, addressing overseas financing and round-trip investment by domestic PRC residents.

Section 3 of Part Four of the New Provisions sets out more specific requirements for the establishment of SPVs and qualifications of a domestic company intending to set up an SPV. A domestic company intending to establish an offshore SPV must first complete MOFCOM verification and approval procedures for outbound investment by Domestic Companies. In cases where an SPV intends to acquire a domestic company by share swap, it must apply to MOFCOM for preliminary approval. This requirement applies regardless of whether a shareholder of the SPV uses SPV shares as payment, or the SPV itself issues new shares as consideration to acquire a domestic company.

The domestic company will be entitled to submit application documents for the overseas IPO by the SPV to the CSRC after receiving preliminary approval from MOFCOM (Article 45, para.1). Following CSRC approval, the domestic company is required to apply to MOFCOM for an FIE approval certificate, bearing the legend "equity held by an overseas SPV; valid for one year from the date of issuance of the business licence" (Article 45).

After the domestic company has conducted an overseas IPO through an SPV, it must submit a report on the situation of the overseas IPO and the IPO proceeds repatriation plan to MOFCOM within 30 days following the IPO (Article 47). Under similar articles of both the New Provisions and Circular 75, the domestic company and residents are required to repatriate all foreign currency income such as profits, dividends and proceeds of'capital changes' obtained from the SPV within six months of their receipt by the SPV, subject to supervision by SAFE. 17

Pursuant to Article 48, the offshore IPO proceeds may be repatriated in the following manner:

i. providing commercial loans to Domestic Companies;

ii. establishing new FIEs in China, and/or

iii. M&A of domestic enterprises.

It is unclear, however, whether and to what extent the IPO proceeds may be used for offshore acquisitions and other business purposes, or to effect a capital increase of the domestic subsidiary.

Anti-monopoly reviews

The New Provisions also include rules on anti-monopoly review of acquisitions of domestic enterprises by foreign investors (Part Five). Generally, the contents of this Part are identical to those of the Tentative Provisions. The New Provisions do contain a slight revision, in that they no longer specify "national welfare, people's livelihood and state economic security", 18 as among the grounds upon which, MOFCOM and the State Administration of Industry and Commerce (SAIC) may require the foreign investors to report the details of the acquisition.

The future validity and application of this part remains unclear, however, in view of the pending draft of the PRC Anti-monopoly Law. 19

Issues and concerns

In essence, many concerns expressed over the New Provisions circle around the likelihood that they will place an unreasonable burden on private market transactions not involving state-owned assets. The costs and uncertainty of compliance - which will be borne primarily by foreign investors - represents an additional cost of doing business and in the balance, quite possibly a deterioration of the investment environment. This, over time, ultimately undermines China's progress towards creating a dynamic and efficient market economy.

Inadequate opportunities for public comment

A draft of the New Provisions was circulated on June 30 2006, 20 among small groups of investment bankers and lawyers, but without any official publication for comment. After some revisions, a second draft dated July 14 was again circulated on a limited basis. On August 8, Xinhua reported that MOFCOM had published a draft of the New Provisions for comment, 21 but to the surprise of observers, the official MOFCOM website published the final, adopted version on the evening of August 9 22 and stated that the New Provisions would come into effect on September 8.

The lack of a genuinely open and meaningful public comment period probably reflects the perceived urgency of greater regulation of foreign-funded M&A activities, quite possibly in response to various interest groups' concerns. But it also reflects a step backward from China's World Trade Organization commitment to greater transparency in the rule-making process. By contrast, the CSRC and various other agencies have in recent years been fairly consistent in publishing drafts for public comment on their official websites, well in advance of the official enactment and promulgation dates. Although the public comment process was less than ideal for a regulatory enactment of such importance, the process of formulating appropriate implementing rules provides ample opportunity for relevant government agencies to obtain genuinely broad-based input.

New application requirements

As mentioned previously, MOFCOM now requires three items (Article 21), in addition to application documents listed in the Tentative Provisions. While the Tentative Provisions mention creditors' agreements and the need for an appraisal report (Article 7 and Article 8 of the Tentative Provisions), they only became mandatory submissions with issuance of the New Provisions, as did the explanation of the relationship between the parties.

These and other submission requirements may invite heightened scrutiny of innocuous private transactions where it is not warranted. For example, the approving authorities may deny approval solely on the basis of appraised value exceeding transaction price, even though the negotiated price is soundly justified based on market changes, defects in the target or other factors. In the case of the creditors' agreement, it would be more appropriate for interested parties to enforce their rights through private causes of action rather than administrative oversight and possibly direct intervention.

Protection of key industries and famous brands

According to Article 12 of the New Provisions, in the case of acquisitions involving key industries that may influence state economic security or may result in the transfer of famous China trademarks ([Chinese characters omitted]) or old China trade names (-?), the parties are required to report the matter to MOFCOM. Obvious questions emerge: what are the "key industries, famous China trademarks and old China trade names", and by what standards will impact on "state economic security" be assessed? Will local'famous' trademarks fall within the scope of filing requirements?

The vagueness and breadth of these criteria demand more precise definition in future implementing rules to create'safe harbour' exemptions from reporting requirements. In the meantime, MOFCOM's power to abort transactions, or order disgorgement of subject assets, when the parties fail to report, will likely result in a flood of superfluous filings. The concerns over possible misuse of these filings and their impact on the approval process forms a cloud of uncertainty over planned and pending M&A deals.

Commercially impractical payment time limits

Article 16 confirms the basic requirement that all purchase consideration should be paid to the sellers within three months. Although extensions are permitted with special approvals (but for not longer than one year), and there is some flexibility as to the form of consideration, this creates a basic tension with commercial realities impacting many M&A deals in China. In particular, unless ameliorated in future implementing rules, this requirement will pose a barrier to extended hold-back and earn-out arrangements. Such payment structures are frequently utilized by buyers to help manage risks of acquiring targets with compliance or structuring problems to resolve, or which are dependent on key individuals for a successful transition.

Problematic anti-monopoly filing and review provisions

Maintaining a healthy and orderly competitive environment is an important governmental function in the market for corporate control. Ideally, an effective anti-monopoly regime should be transparent, based on publicly available standards and applied in an even-handed manner. Concerns over legacy administrative monopolies in China and other issues have continued to delay finalization and adoption of the draft PRC Anti-monopoly Law, although there has been meaningful recent progress with the draft endorsed by the State Council on June 7 2006 and the fact that purely domestic M&A activity has substantially outpaced M&A by foreign investors. 23

The anti-monopoly rules in the New Provisions are inherently protectionists. The potential for a 90-day review period with public hearings (Article 52) and the lack of an administrative appeals procedure presents a material and potentially costly burden imposed on foreign buyers that is not currently imposed on domestic purchasers.

Even if MOFCOM and the SAIC make a determination that a proposed transaction has no anti-competitive impact, there is no time limit specified for this threshold finding, which may potentially result in fatal delays to a time-sensitive transaction. By focusing on the status of the parties, rather than the nature of the transaction at hand, existing foreign investors that have already made a substantial commitment to China will be penalized by having even small, inconsequential transactions that will be universally subject to filing and at least preliminary review procedures.

Impractical filing thresholds

The filing thresholds listed in Article 51 of the New Provisions are simply too arbitrary to provide a meaningful standard for heightened scrutiny. For example, a report must be filed when one party to the transaction has turnover on the Chinese market of at least Rmb1.5 billion (approximately US$189.7million) (Article 51(1)). In the case of a diversified company with various business lines in distinct industries, this threshold is irrelevant to competitive impact. Even in the case of a single product company, this turnover figure will be relatively insignificant, for instance, in the petrochemical or automobile manufacturing industries. The criteria of having acquired over 10 enterprises in a related industry in the past year (Article 51(2)) will also have little meaning in certain industries, such as fast food or small retail outlets. Thresholds tied to China market share are in need of clearer guidance as to definition of'market' from industry to industry.

Similar concerns are present in the case of reporting requirements for overseas M&A transactions involving parties with investments in or sales into China. The first filing threshold criteria, "assets in excess of Rmb3 billion in China" (Article 53(1)), would automatically subject many larger investors, for example those that have established petrochemical plants or infrastructure projects, to filing and review requirements for any acquisition - regardless of size or impact on China - for which they are required to publicly announce a merger or acquisition plan or submit anti-monopoly filings in any other country. While Article 53 states no penalties for failure to file reports in respect of subject offshore M&A transactions, nor consequences of disapproval by MOFCOM or the SAIC, the lack of transparency in the anti-monopoly review process leaves open the possibly of retribution when approval of domestic or cross-border M&A transactions is sought in the future.

Anti-monopoly review process: risk of politicization

Even in transactions which do not otherwise reach reporting thresholds, upon application by competitors, government authorities or industry associations, MOFCOM and the SAIC may require the foreign investor to report the acquisition if they consider that it actually involves very substantial market share or involves factors that may seriously influence competition (Article 51). The concern here is that domestic competitors and other interested parties have a tactical weapon to delay acquisitions. It would certainly be preferable to suspend application of the anti-monopoly rules in the New Provisions indefinitely, and allow them to be pre-empted by adoption of a universal and well-administered anti-monopoly law.

How viable are acquisitions by share swaps?

One of the most welcome developments in the New Provisions is recognition of overseas listed shares as a permissible form of acquisition currency (Part Four). This would, if implemented, stand to benefit China's emerging technology industries by facilitating liquidity and greater integration with the global economy. On closer examination, however, share-for-share deals may in practice be limited as a viable deal structure.

De-facto operating history requirements

Article 28 and Article 41 of the New Provisions state a requirement that applicants must not have any record of penalties within the previous three years. Would this imply that listed shares of companies less than three-years-old, do not qualify as purchase consideration? This could potentially exclude many purchasers that may have been re-organized under new corporate vehicles prior to going public.

Requirement of share price stability

Article 29(4) requires that the price of overseas company shares to be 'stable' within the previous one year. Particularly in high-technology and creative industries involving young and emerging companies, share price volatility is often the rule and not the exception. Precluding share-for-share deals for this reason would tend to reduce liquidity of investment in industries where it is most needed to help foster innovation. Moreover, given the numerous, unpredictable factors generally impacting securities markets, price stability per se is simply not an appropriate criterion. If anything, it may better serve China's policy interests to encourage acquisitions paid for with shares, since they hold out the possibility of deferring problematic foreign currency inflows.

Limited availability of M&A consultants

Pursuant to Article 30 and Article 31(3), the mandatory M&A Consultants are required to be registered in China and have the ability to research and analyze the legal systems of the foreign purchaser's place of incorporation and place of listing, and to research and analyze the foreign purchaser's financial condition. If the intention is that M&A Consultants must be brokerages or investment banks incorporated in China, unless they are permitted to engage international law firms and investment banks as their advisers, the pool of qualified M&A Consultants may be so small, as to be a serious impediment to executing share-for-share acquisitions. A clarification in the future implementing rules permitting foreign investment banks with registered representative offices in China to serve as M&A consultants, would go far toward removing this potential obstacle. Moreover, if the domestic target is a listed company there is also a question of potentially redundant CSRC 24 and MOFCOM requirements on financial consultants and M&A Consultants, respectively.

Accountability for rejection of applications

Paragraph 1 of Article 25 does not require approval authorities, either provincial Commission of Foreign Trade and Economic Cooperation (COFTEC) or MOFCOM, to provide any reason for rejecting applications for acquisition approval. Unless this is remedied in detailed implementing rules, this will represent the reversal of a positive trend toward greater transparency and accountability of government when making negative approval decisions.

Possible delays in pre-IPO approvals

Based on Section 3 of Part Four, in order to conduct an overseas IPO, the domestic company must first apply to MOFCOM for approval of a share swap by the domestic company with the SPV. However, there appears to be no time limits for MOFCOM to respond (Article 45). A material delay by MOFCOM in approving may cause an otherwise promising overseas IPO to miss a potentially narrow listing window, following expenditure of substantial resources in preparation.

A litmus test for foreign-funded M&As

In principle, foreign investors should welcome the New Provisions, provided their defects are remedied in well-crafted implementing rules. They can, arguably, bring greater transparency to the government's role in foreign-funded M&A and now permit use of foreign-listed shares as acquisition currency. If strictly or arbitrarily implemented as drafted, however, the New Provisions may well impose obstacles to future acquisitions of Domestic Companies and asset deals involving FIEs by foreign purchasers. Particularly given MOFCOM will have final say on a greater percentage of acquisitions, the time required to obtain all necessary approvals may be unpredictable and kill many promising deals. It is also likely that even if the parties received local government approvals, the politicization of the anti-monopoly and central government review process could result in damaging delays of uncertain duration. The pending acquisition of Xuzhou Construction Machinery Group by the Carlyle Group is a case on point, since agreement was reached in early October 2005 and is still awaiting final approval. 25

In a sense, it is fortuitous that there are three pending high-profile acquisitions that have encountered obstacles: the objection from an industry association to acquisition of Luoyang Group, criticism of a low state asset sale price in the proposed acquisition of the Xuzhou Group and the objections by six domestic competitors to acquisition of Supor. These are useful test cases under the New Provisions.

The Xuzhou Group is the leading domestic manufacturer of construction machinery and the parent company of a Shenzhen Stock Exchange (SSE)-listed company, Xugong Tech, 26 and commands over 50% 27 of China market share. The Luoyang Group is one of the top three manufacturers in the Chinese bearing industry. It falls within the scope of'key industries' and even has a subsidiary manufacturing mission-critical equipment used in China's spacecraft. 28 Supor, an SSE-listed company and a China cookware industry leader, not only holds market share exceeding 20%, but also owns a'famous trademark' 29 officially recognized by the SAIC.

The final outcome of each of these three pending acquisitions, whatever the result, will be an important litmus test of actual central government policies toward foreign-funded M&A, particularly given the likelihood that FIE-specific investment incentives will eventually be phased out and official treatment of foreign-funded M&A may remain the most important foreign investment policy of all.

Endnotes

* Some comments and observations under the heading 'Issues and concerns' in this article were gleaned from informal communications with the international business and legal community in China and are not the original ideas of the authors.

1 ' UK spent $3.5 billion in China M&A takeaway', August 15 2006. See the Grant Thornton website (www.grant-thornton.co.uk).

2 The New Provisions were jointly issued by the Ministry of Commerce (MOFCOM), the State Asset Supervision and Administration Committee (SASAC) of the State Council, the General Taxation of State (GTS), the State Administration of Industry and Commerce (SAIC), the China Security Regulatory Commission (CSRC) and the State Administration of Foreign Exchange (SAFE).

3 The Tentative Provisions were jointly issued by the Ministry of Foreign Trade & Economic Cooperation, the GTS, the SAIC and SAFE on March 7 2003.

4 See Neumann, P., Private Acquisitions by Foreign Investors in China : Is the Party Finally Over? China Law & Practice, April 2003, Vol.17, No.3, pg 13.

5 The Acquisition of Listed Companies Administrative Procedures (Takeover Code) issued by the CSRC on July 31 2006, effective on September 1 2006 (see page 31 in this issue of China Law & Practice for a detailed discussion of the Takeover Code); Guiding Opinions on the Reform Regarding the Separation of Equity Ownership and Trading Rights of Listed Companies jointly issued by CSRC, SASAC, Ministry of Finance, People's Bank of China and MOFCOM ([Chinese characters omitted]) on August 23 2005; Circular on Issues Relevant to the Separation of Equity Ownership and Trading Rights of Listed Companies that Involves Foreign Investment Administration ([Chinese characters omitted]) jointly issued by MOFCOM and CSRC on October 26 2005.

6 The Measures for the Administration of Strategic Investment in Listed Companies by Foreign Investors issued by MOFCOM, effective on February 1 2006.

7 The Tentative Provisions on Using Foreign Investment to Reorganize Foreign-owned Enterprises by four state agencies, effective on January 1 2003 and the Tentative Measures for the Administration of the Assignment of Enterprise State-owned Assets and Equity issued by the SASAC and the Ministry of Finance, effective on February 1 2004.

8 The Tentative Measures for the Administration of the Check and Approval of Foreign-invested Projects issued by the NDRC effective on October 9 2004.

9 'Listing industries that are off-Limits to foreign acquisitions', The Economic Observer, September 2 2006. See the Xinhua website (www.news.xinhuanet.com).

10 'SEB tender offer report', August 16 2006, SSE, SEB may choose to hold at most 61% shares of Supor in 12-month stages. The term of tender offer was from August 17 2006 to September 17 2006. SEB will purchase more shares from Supor shareholders and subscribe for direct sale of 40 million shares by Supor in the next 12 months. See the Sina website (www.sina.com.cn).

11 Six domestic competitors gathered in Beijing and provided a written declaration on August 8 2006, appealing to MOFCOM and other state anti-monopoly authorities to investigate the acquisition of Supor by SEB. See the Sina website (www.sina.com.cn).

12 Where regulations governing the merger and splitting of FIES, and domestic investment by FIEs are silent on M&A by existing FIEs, transactions should be handled with reference to the New Provisions. See Article 55, para.3 of the New Provisions.

13 Where an FIE merges or acquires domestic enterprises, the transaction should be handled under the existing provisions that govern the merge and division of FIEs and the existing provisions on domestic investments of FIEs; where existing regulations are silent, the New Provisions are applicable. See Article 55, para.3 of the New Provisions.

14 Article 3 of the Provisions on Merge and Division of Foreign-invested Enterprises issued by Ministry of Foreign Trade & Economic Cooperation and the SAIC, effective on September 23 1999 and the Tentative Provisions on Investment Within China by Foreign Investment Enterprises issued by Ministry of Foreign Trade & Economic Cooperation and the SAIC on July 25 2000, effective on September 1 2000.

15 Article 21 para.10 and Article 23 para.9 of the New Provisions.

16 Article 4 and Article 12 of the Provisions on the Check and Approval of Outbound Investment and Establishing Overseas Enterprises issued by MOFCOM, effective on October 1 2004.

17 Article 48 para.3 of the New Provisions; Article 6 para.2 of Circular 75.

18 Article 51 para.2 of the New Provisions; Article 19 para.2 of the Tentative Provisions.

19 Note: as a formal'law' passed by the NPC, unless it provides to the contrary, the PRC Anti-monopoly Law would, in theory, pre-empt anti-monopoly provisions of the New Provisions.

20 'The release of the new M&A provisions', September 11 2006. See the China CEO website (www.cnceo.com).

21 'New M&A provisions permits share swaps', on August 8 2006. See the Xinhua website (www.news.xinhuanet.com).

22 'New Provisions issued by six central government authorities', August 9 2006. See the MOFCOM website (www.mofcom.gov.cn).

23 On one account, "M&A deals in China reached US$41 billion in the first half of 2006, up a staggering 71% year-on-year. In 2005, the number of announced deals climbed 14.5% year-on-year to 857", 'Takeover fever heats up', China International Business, Issue 226, September 2006, pg 46 (article attributed to Standard & Poor's). See also note 1.

24 See the requirements for financial consultant in the takeover of listed companies in the Takeover Code.

25 'Xugong acquisition fighting', July 24 2006. See the Xinhua website (www.news.xinhuanet.com).

26 'Xugong technology listed in Shenzhen Stock Exchange', November 26 2004. See the Sina website (www.sina.com.cn).

27 'Sanyi Group challenges Xugong acquisition', June 15 2006. See the Xinhua website (www.news.xinhuanet.com).

28 'China Bearing Association opposes Luoyang Bearing acquisition', July 6 2006. See the Jinrongjie website (www.news.jrj.com).

29 'SEB acquired Supor', September 6 2006. See the Xinhua website (www.news.xinhuanet.com).