PRC MA

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The Art of Mergers & Acquisitions in China

White & Case September 13, 2006

Professor Shen Wei

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Topics

1. Preparation and Strategy

2. The On-the-Ground Reality

3. Closing a Deal and Achieving an Exit

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Preparation and Strategy

A. Overview of the M&A practice in China

- China is definitely on the radar: internationally and domestically

- Moving from greenfield projects to more M&A transactions

- More industry sectors open to foreign investors

- Hot industries include telecoms, financial, energy, mining, retail,

pharmaceuticals, machinery, automobile …

- Two-folded policy concerns

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B. Some basic concepts in the M&A practice in China

- Inbound M&A vs. outbound M&A

- public company vs. private company

- asset deal vs. equity deal

- transaction modes: share purchase, share swap

- various targets: SOEs, FIEs, pure domestic entities

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C. Recent Developments in the M&A practice in China

- Increasing number of “private equity” led deals

- Protection of key industries from foreign takeovers – a case of

deja ru?

- Share reform of listed companies

- C, G and legal person shares

- Using stock for acquisitions

How do these changes affect the market?

What are the implications?

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Box 1 - Alphabet Soup

Domestic Exchange

Foreign/Hong Kong Exchange

Non-tradable

One share class denominated in RMB

Domestic-invested

Traded in RMB - A Shares G Shares

Not possible C Shares

Foreign-invested

Traded in foreign currency – B Shares

Traded in foreign currency: H Shares – Hong Kong N Shares – New York T, S, L etc.

Not possible

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D. Recent Regulatory Developments in the M&A practice in China - New Company Law 2005

- New Securities Law 2005

- Rules for Mergers with and Acquisitions of Domestic Enterprises by

Foreign Investors 2006

- Takeover Rules of Listed Companies 2006

- Administrative Measures on Strategic Investment in Listed Companies by

Foreign Investors 2005

- Others i.e., infamous SAFE Notices

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D. Recent Regulatory Developments in the M&A practice in China (con’d)

- China is evolving towards a more sophisticated legal regime for

M&A transactions

- Good news:

¾ Clearer approval requirements and procedures

¾ More experienced local players and government authorities

¾ Adoption of new transactional tools such as share swap

- Bad news:

¾ More new limitations and restrictions imposed

¾ Approval authorities now have more discretionary powers

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Box 2 – MOFCOM

• MOFCOM’s discretionary power

- Any deal involving a key industry or well-known brand, or may affect

national economic security shall be filed with MOFCOM (Article 12 of the

M&A Rules 2006)

- Possible key industries include ¾ Nuclear power

¾ Military

¾ Machinery

¾ Power generation/transmission

¾ Shipbuilding

¾ steel

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Box 2 – MOFCOM

• MOFCOM’s discretionary power

- MOFCOM may stop a deal if it has grounds to believe that it will affect

national economic security – similar to US CFIUS Review

- Vagueness in rules escalates uncertainty in deals

- Coca-cola & Huiyuan

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Preparation & Strategy

E. Winning Strategies

- Keep abreast of new developments

- Cultivate local partners

- Understand the counterparty

- Cultural sensitivity not cultural blindness

- Adjust time lines (forward or backward) and manage expectations with

home office

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Box 3 – Cultivate local partners

• Watch out for Foreign Corrupt Practices Act issues

- many commercial entitles have State-owned links

- Companies may keep different sets of accounts

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The On-the-Ground Reality

F. Navigating the Chinese Regulatory Regime and doing deals in heavily regulated industries

- Investing in heavily regulated industries

- The Encouraged, Restricted, Permitted and Prohibited or “The Good,

Bad and the Ugly”

- Foreign ownership caps

- Good nominee structures, bad nominee structures

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Box 4 – Foreign ownership caps

Strategic Investor

Strategic Investor

Financial Investor

Foreign sub of PRC company

PRC anchor investor

Public shareholders

Domestic Bank

Outside China

China

Individual cap?

Impact ?

Foreign consortium cap ?

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Box 5 – “Bad” Nominee Structure – telecom CCF arrangements

Foreign telco China Unicom

Provincial Subsidiary

Cooperation Joint Venture Operation Agreement

local network

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Box 6 – I got your “number”

Foreign Publishing

House PRC

company

Magazine Name

(publication number)

Brand Name

Cannibalisation

Copyright Cooperation

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Box 7 – Value–added telecoms

Founders’ Investment Vehicle

Public

Listco

Operating Vehicle Founders

License holder Unregulated

Business Regulated Business

Nominee contract

Security and Cash

Extraction Contracts

China

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G. Regulators

MOFCOM

SAIC

SAFE

Customs

EPB

SASAC

NDRC

CSRC

CBRC

CIRC

MII

SAPP

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G. Regulators (con’d)

Central MOFCOM

Local MOFCOM

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H. State-Owned Enterprises - Recent developments

- Xugong, Chenming

- Deal drivers

- Which member of the group?

- Dealing with the Hong Kong listed member

- Parent guarantee?

- State-owned assets valuation (mandatory, licensed appraising firm, methodology,

SASAC’s confirmation)

- Payment terms (90% rule)

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H. State-Owned Enterprises (cont’d)

- Special considerations - Diligence

- Procedure (involvement of the asset exchange centre)

- Timing

- Documentation

- Social obligations

- Cross-provincial consolidation

- Sovereign immunity

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Box 8 – The Hong Kong listed member

Foreign investors

HK listco

SOE

Connected transactions

Onshore Operating Vehicle

- Hong Kong Stock Exchange issues - Disclosure of interests - Hong Kong Takeovers Code issues - Insider dealing issues - Pricing issues and the “halo effect”

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I. The Public Company - Share reform

- The good news, the bad news

- Theme is convergence

- Special considerations

- Investor qualification

- Public bid process

- Lock-up

- Diligence – insider trading issues

- Timing – pricing and approval process(es)

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I. The Public Company (cont’d) - Trading restrictions

- Disclosure of interests

- Connected transactions

- Listed Company Takeover Rules

- Mandatory Offers

- Partial offers

- Stock as acquisition currency

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J. The Private Company

- M&A Rules 2006

- Multi-agency effort

- Approval for acquisitions of key industries, famous Chinese brands

- Deals affecting state economic security

- Stock deals

- Merger Control

- May be inconsistently applied across China

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J. The Private Company (cont’d) - Special Considerations

- If privatized, was it privatized properly?

- Offshore control vs. onshore control – using a holdco

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K. Investment Funds, Hedge Funds and other Alternative Investors - Meeting investor qualification criteria - Prejudice against financial investors? - Opportunities and risks

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Closing a Deal and Achieving an Exit

L. M&A Roadmap for M&A Transactions in China Important Milestones in an M&A Transaction

– MOU – Pre-deal restructuring – Due Diligence – Reps and warranties – Pre-closing conditions – Closing – Post-closing matters

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L. M&A Roadmap for M&A Transactions in China (con’d)

– Negotiation ¾ Identify the target ¾ Sign a Term Sheet/LOI/MOU/Heads of Agreement ¾ Commercial/legal negotiation ¾ Due Diligence (legal, financial, commercial, technological) ¾ Prepare definitive agreements

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– Approval ¾ MOFCOM approval ¾ Approval by the industry watchdog(s) ¾ SASAC approval ¾ Anti-trust filing ¾ New business license ¾ SAFE approval ¾ Others

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– Closing ¾ Clear up key findings in due diligence ¾ Prepare the disclosure letter ¾ Pre-closing audit (financial due diligence) ¾ Conditions precedent (to be satisfied or waived) ¾ Payment of consideration ¾ Post-closing integration

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M. Critical Factors in Structuring M&A Deals

– Structure-out problems – Structure for growth – Structure for new problems

• “When planning the marriage, consider the divorce” – Structure for Exit – Structure for Taxes/Dividends – Structure to satisfy the regulators

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Box 9 – Structure for growth

Foreign Investor

Holding Company

Operating Company

- building a brand - centralized distribution, procurement and infrastructure - floating cash layer

Operating Company

Operating Company

Operating Company

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Box 10 – Structure for exit

Foreign Investor

HK SPV

JV “Crown Jewel”

JV JV JV to be retained

The case of the Crown Jewel

Foreign Investor

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N. Due Diligence

- Legal due diligence (not an exhaustive list) ¾ Incorporation of the target (approval and registration, transfer of equity) ¾ Capital verification of all contributions to registered capital ¾ Legal rights in respect of land and buildings ¾ Environmental survey in respect of the relevant land and facilities ¾ Tax status including any preferential benefits enjoyed with respect to both

income tax and imported equipment ¾ Existence of any business relationship with third parties such as suppliers,

franchisees, customers, banks, lessors, etc. which may prevent or hinder proposed investment

¾ Identify key employees whose continued participation in the relevant business would be of strategic importance, employee settlement plan, labor related costs, labor redundancy, etc.

¾ Status of IP rights, e.g., trademarks, patents, know-how, copyrights, software, enterprise names, domain names, licenses, etc.)

¾ Assets (SOE assets, ownership, encumbrances or third party claims)

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N. Due Diligence (con’d)

- Non-compliance is widespread - No target company (in particular in China) is 100% clean - Risks shall be properly assessed from both legal and practical perspectives

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Closing a Deal and Achieving an Exit O. Instruments to Lower Legal Risks

- Closing conditions – corrective measures to tackle due diligence findings

- Payment of consideration ¾ escrow account, holdback, earn-out, buy-back (?) ¾ default payment timeframe: 3 months of the issuance of a new business license,

extendable to 1 year, provided 60% is paid within 6 months - Reps and Warranties - Indemnity - Unilateral termination ¾ reasonable/practical triggers ¾ Exit - Post-closing covenants

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P. Current Exit Strategies

- Trade sale - IPO

- Domestic - NY, London, HK, SG

- MBO/LBO - Private Equity

- MBO - LBO - “recycled deals”

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Q. Critical Post-Closing Issues - Protect IP

- Employment / Labor Issues

- Confidential information risks

- Foreign Exchange

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Q. Critical Post-Closing Issues (cont’d) - Relationship with other investors

- Business risks

- Regulatory risks

- Dividends

- Expansion

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R. Anti-trust Filing - Most anti-trust filings have been procedural but it is expected to have more

teeth

- Thresholds for the anti-trust filing are rather low

¾ Turnover of a party to the transaction in China exceeds RMB 1.5bn during the year

¾ The foreign party has cumulatively acquired more than 10 domestic enterprises in one year

¾ Current (pre-M&A) market share of a party already exceeds 20% in China

¾ Post-deal market share of a party will exceed 25% in China

- Anti-trust review may be requested by domestic competitors, relevant

organizations or industrial associations

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R. Anti-trust Filing (con’d) - Watch out: offshore M&As may also be subject to anti-trust filing in China if

certain thresholds are met

¾ Any offshore party holds assets in China of over RMB 3 bn

¾ Volume of business in China of any offshore party is over RMB 1.5 bn

¾ An offshore party has reached a market share in China of 20%

¾ The transaction will result in an offshore party attaining a market share of 25% in China

¾ The result of the transaction will make an offshore party have direct and indirect ownership

in over 15 FIEs in the relevant industry or area

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R. Anti-trust Filing (con’d)

- Problems

¾ Relevant market (Articles 51 and 53 of the M&A Rules)

¾ Affiliate (Article 51)

¾ Offshore acquisition (Article 53)

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S. National Security Review - the Notice on Establishing National Security Review Mechanism for Mergers

and Acquisitions of Domestic Enterprises by Foreign Investors [Guo Ban Fa

[2011] Circular 6], issued by the General Office of the State Council on 3

February 2011

- the Interim Rules on Issues Related to the Implementation of the Security

Review System for Mergers and Acquisitions of Domestic Enterprises by

Foreign Investors, issued by the Ministry of Commerce on 4 March 2011

- the Regulations on the Implementation of the Security Review System for

Mergers and Acquisitions of Domestic Enterprises by Foreign Investors,

Announcement [2011] No.53, issued by the Ministry of Commerce and effective

as of 1 September 2011

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S. National Security Clearance: the targets subject to national security reveiw

Category A Category B Where the target is a military industry enterprise

Where target involves agricultural products

A supporting enterprise for military industry enterprise

Where target is related to energy sources & resources

An enterprise located close to sensitive military facilities

Where target is related to infrastructure Where target is related to transportation services Where target is related to technologies Where target is related to equipment manufacturing

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S. National Security Review: the target subject to the review

- BUT still uncertain whether all foreign investors in all M&A transactions

must file an application with the MOFCOM or whether it is only those

transactions that fall within the scope of the security review circular

� a list of “considered factors” in Circular 6

� “any other scenarios which would cause the rights to exercise actual control over

operational decisions, financial personnel and technological affairs of a domestic

company”

� practical meaning is that the list can be further extended

- Small transactions – exempted? Cf. Australia FIRB

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S. National Security Clearance: procedure

Step Timing Notification to MOFCOM

(not specified)

MOFCOM notifies the Ministerial Panel if the transaction falls within the scope of the security review

5 working days

Ministerial Panel general review: •Request opinions from other departments •Opinions from other departments •Decision (either dismissing or proceeding to a special review)

•5 working days •20 working days •5 working days

Ministerial Panel special review

60 working days

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S. National Security Review: A Paper Tiger??

- Injecting another layer of uncertainty

- Who can initiate the procedure?

- Review measures will be used as frequently as the AML

- Requires substantial disclosure and may cause more delays

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