China tends to give bureaucrats lots of room to interpret its loosely worded laws, so it's still early to tell how the changes made in September 2006 to its acquisition rules will play out. But there are some signs of a backlash against foreign investment. In November, for example, the powerful National Development and Reform Commission warned that emerging monopolies by foreign-invested companies could hurt China. Against that backdrop, Corporate Dealmaker's K.C. Swanson spoke with lawyer Howard Chao about the meaning of the recent legal revisions. Chao, a 26-year veteran at O'Melveny & Myers LLP and Mandarin speaker, is partner in charge of the firm's Asia practice. Excerpts:
Corporate Dealmaker: Can you explain how changes in the M&A regulations might affect foreign investors?
Howard Chao: It depends on who you are and what kinds of investments you're trying to make. The new regulations do several things.
One section requests you to make a special filing if you're a foreign investor buying a Chinese business in a sensitive sector. There are three criteria that can trigger this: if the deal involves a major industry, if it could have an impact on national economic security, or if it could result in the transfer of famous trademarks or traditional Chinese brands. It's a little like the Committee on Foreign Investment in the U.S.
The vagueness of the Chinese requirement has caused concern. But maybe it's not so different from U.S. rules?
Well, the Exon-Florio statute, which CFIUS administers, is itself very vague. There's some verbiage about national security. But what's that? Did Unocal affect national security? [In 2005, Chinese oil concern CNOOC's takeover bid for American energy firm Unocal was foiled in part by fierce opposition from the U.S. Congress]. That never got to CFIUS. But if you're trying to compare degrees of vagueness, the U.S. statute is very vague too.
That said, there's been some concern that the new rules in China will make it easier for bureaucrats to block foreign acquirers. What's your opinion?
The rules themselves don't really say very much -- just that before you do this kind of deal, you have to file a notification with the government. It's an additional level of scrutiny, separate from the requirement of getting the approval for your deal. How onerous is it? It will depend on how the government authorities exercise their discretion, and we haven't seen much history yet. But clearly it does evidence a shift in general attitude on the part of government authorities.
There's been talk about a backlash against foreign acquirers. For example, Carlyle's attempt to buy Xugong, a Chinese machinery maker, has been delayed since 2005, and it's had to cut its planned stake to 50% from 85%. Citigroup also had to cut its stake in Guangdong Development Bank from 40% to 20% before that deal got approved late last year. Are the rule changes part of a bigger picture?
I think it's more than a coincidence. It's due to the fact that, No. 1, the government saw that other countries are very sensitive to this, No. 2, that China is increasingly a more nationalistic place, and No. 3, that they don't need foreign investment as much, frankly, as they used to.
How much is Beijing worried about foreigners making huge profits off deals in China?
There has always been a line of reasoning in China that foreigners should never make obscene profits; that's been a recurring theme toward foreign investment. You can see this over the past 25 years, how the Chinese government has tried to limit returns in various areas -- that if you're doing power deals, for example, you should not get a return of more than 15%. There have been all these government-stipulated levels of return to avoid the possibility of foreigners making unbounded rates of return. So that line of thinking probably continues in some circles, though it's no longer embedded deeply in the laws and regulations.
Another important rule change relates to foreign financial investors and their use of offshore holding companies to make acquisitions in China. Can you explain this?
Historically with this kind of acquisition, foreign financial investors that came upon a company owned by domestic Chinese shareholders would set up and fund an offshore holding company in a place like the Caymans or the British Virgin Islands. The shareholders of the domestic company would become shareholders of the offshore company too. After the offshore company was set up, it bought the domestic company and made it a subsidiary.
The reason for this is it's a lot easier to sell an offshore company or take it public. You can't take a Chinese domestic company public very easily; you have to get Chinese government approvals. There are also a lot of other legal disadvantages in using a domestic company. So people have wanted to have an offshore holding company structure.
But under the new rules, transactions like these, which involve a "round-trip" affiliate purchase, will have to receive approval from MofCom [the Ministry of Commerce]. In the past where the transaction size was small enough, often it could just receive provincial-level approval. MofCom tends to be less flexible than provincial-level authorities, and they can take a lot longer.
The change has impacted many financial investors who need to do the roundtrip transaction to set up the offshore holding company. But it has not affected corporate investors who are just buying Chinese companies for cash, because there's no roundtrip affiliate transaction.
Why did Beijing decided to increase scrutiny of these kinds of deals now?
Private equity and venture investing in China has been happening for the past 10 years, and it has effectively converted a large number of domestic companies from pure domestic companies to subsidiaries of foreign companies.
But foreign-owned subsidiaries are very different animals when it comes to Chinese law. They can pay all their profits offshore through dividends, and their shareholders -- including Chinese citizens -- had the ability to earn foreign currency income and keep money offshore. Also foreign-invested enterprises historically have had lower tax rates or tax holidays. The Chinese government has less control over these companies when they become offshore holding companies.
Another change is that foreign companies can now use their shares to buy into Chinese companies. Is this significant?
I'm not sure how big a deal I would make out of that. There are a couple of provisions in the M&A regulations permitting share swaps. One says you can do share swaps in anticipation of an [initial public offering]. But that's unlikely, frankly, because the rule also says if you don't do the IPO within 12 months, you'll have to unwind it. Well, no one can really be sure they can do the IPO within 12 months. Doing a share swap with that kind of threat over your head is not something many people will want to live with.
In the past foreign investors have been useful as a source of cash, as a way to boost the credibility of Chinese companies and possibly also to help them prep for an IPO overseas. But now some Chinese companies can afford to make pricey acquisitions of other domestic companies. And with China's own capital markets getting stronger and deeper, maybe Chinese companies will have less interest in listing overseas. Are outside investors becoming less important?
If you're talking about an IPO of real scale, people still have to go international today. Although the domestic markets will continue to get bigger over time, people who really want to be playing at the top rung of the competitive marketplace still think they need to have a listing offshore in Hong Kong or New York. And you still want your offering to be successful, so why wouldn't you want to have a leading foreign strategic investor as one of your shareholders before you do your IPO? I'm not sure the logic has changed.
In your experience, how are foreign acquirers changing their strategies?
Among foreign financial investors affected by the new measure on round-tripping, there has been a lot more venture capital investment made directly in Chinese companies through onshore joint venture structures. Also, I'm working on quite a few foreign-invested renminbi-denominated venture funds. These allow people to move a lot faster in making deals in China. CD
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