MERGERS & ACQUISITIONS
Trends and Developments: Takeovers of Listed Company Targets
October 6, 2006
Robert Lewis, Lovells Beijing

M&A is a high profile topic in China at present. Even though these cross-border acquisitions in both directions have been relatively few to date, most observers anticipate that both in-bound and out-bound M&A transactions will become increasingly important in the China market in the medium to long term.

In an effort to try to keep pace with this new reality in the marketplace, the legal landscape relating to M&A transactions in China is also changing. For example, the Regulations on the Takeover of Listed Companies were issued 31 July 2006 and took effect 1 Sept. 2006 ("2006 Takeover Regulations"), which replace the Regulations of the same name issued 28 Sept. 2002 and effective as of 1 Dec. 2002 ("2002 Takeover Regulations"), and the Regulations on Acquisitions of Domestic Enterprises by Foreign Investors were issued 9 August 2006 and will take effect 8 Sept. 2006 ("2006 Cross-Border M&A Regulations"), which replace the earlier 2003 cross-border M&A rules.  Both of these new regulations should also be viewed against the backdrop of the new Company Law, which came into effect in January. 

From the perspective of an international investor, the current legal and commercial environment in China already presents numerous obstacles to acquisitions by foreign companies of domestic companies, particularly domestic listed companies.  As a practical matter, there are only a limited number of potential domestic listed targets for cross-border acquisition by foreign parties, which is a reflection of the relatively underdeveloped state of the capital markets in China to date.  Fewer than 20 reported public company takeovers have taken place to date in China and even fewer involving foreign acquirers. The trend of cross-border acquisitions will continue to accelerate, however, over the medium to long term in China as business imperatives dictate the pursuit of strategic acquisitions. 

To illustrate the projected impact of the new rules in the context of standard global M&A practices, the following case study has been prepared involving a hypothetical foreign acquirer ("International Corp.") and a hypothetical domestic public target ("Target") and seller ("Seller").  In this case study, the Target is a listed company in China, and International Corp. intends to purchase of 51% of the non-tradable shares in the Target from the Seller, which holds 60% of the total outstanding shares prior to the proposed acquisition.  The remaining 40% shares are widely held by public shareholders.  

1. DEAL STRUCTURE
Under both the 2002 and 2006 Takeover Regulations, because International Corp. is to acquire more than 30% of the shares of the Target, International Corp. is required to make a tender offer to all of the shareholders of the Target.  The difference is that under the 2006 Takeover Regulations, in most cases the acquirer is allowed to make a partial offer to all shareholders for the remaining shares, rather than making a general offer to all shareholders for the entire remaining capital as required under the 2002 Takeover Regulations.  However, under a plain reading of 2006 Takeover Regulations, an acquirer can purchase by agreement only 30% of the shares of the Target, and the balance to be acquired by the acquirer must be purchased pursuant to the general offer or partial offer to all shareholders. 

This presents some possible structuring options for International Corp. and Seller.  International Corp. can enter into a share purchase agreement ("SPA") with the Seller for the purchase of 30% of the shares and then make a partial offer to buy a total of 21% from all shareholders including the Seller. If none of the public shareholders tender their shares, then International Corp. can purchase the additional 21% from the Seller pursuant to a separate undertaking from the Seller. 

Of course, this presents some risks to both parties.  The Seller may have the objective of selling down the full 51% of the shares to International Corp., so the Seller may require a guaranteed undertaking from International Corp. to purchase not less than 51% of the shares from the Seller irrespective of the response to the general or partial offer on the part of the other public shareholders.  On the other hand, International Corp. likely will want to guarantee that it will be able to acquire not less than 51% but perhaps not want to be required to purchase more than 51% so may not want to bear the risk that public shareholders may in fact tender their shares.  This may result in an impasse.

2. WAIVER OF GENERAL OFFER REQUIREMENTS
Under both the 2002 and the 2006 Takeover Regulations, certain categories of acquirers can obtain an exemption from the mandatory general offer obligations.  An acquirer may apply to the CSRC for exemption most commonly in the following situations:

1. Intra-group transfers (i.e. the actual controlling party is unchanged);
2. White-knight takeovers (i.e. the target is in serious financial difficulty and the acquirer intends and is able to effect a rescue); and
3. The acquirer ends up holding or controlling more than 30% because the target issues new shares or reduces its share capital, or the acquirer exceeds such threshold due to a court judgement, inheritance, succession or administrative allocation of state owned assets.

In the past, the CSRC was reasonably liberal in granting waivers, but recently it has become much more difficult to obtain a waiver without meeting one of the three specific exemptions listed above.

One additional change to the waiver rules under the 2006 Takeover Regulations: a shareholder holding 30% or more of the shares may apply to the CSRC for a waiver if it intends to increase its stake no more than 2% within any 12-month period, provided that no such increase in shareholding is made within the first year after it obtains its aggregate shareholding in excess of the 30% minimum threshold.  This new rule gives controlling shareholders more flexibility to top up their shareholdings incrementally over time.

3. PRICING
Another key feature of the 2006 Takeover Regulations is to remove the separate pricing mechanism for non-tradable shares as well as soften the pricing formula for tradable shares. 

Under the 2002 Takeover Regulations, the offer price for non-tradable shares had to be at least the higher of: (i) the highest price that the acquirer has paid for the same class of non-tradable shares during the six months before the initial announcement; and (ii) the target’s latest audited net asset value per share.  For tradable shares, the minimum offer price had to be the higher of (i) the highest price that the acquirer has paid for the same class of tradable shares during the six months before the initial announcement; and (ii) 90% of the arithmetic mean of the daily weighted average prices of the same class of tradable shares during the 30 days before the initial announcement.

The 2006 Takeover Regulations no longer distinguish between non-tradable shares and tradable shares for pricing purposes, and the only pricing method provided for under the 2006 Takeover Regulations simply requires that the offer price may not be below the highest price that the acquirer has paid for the same class of shares during the six months before the initial announcement.  Moreover, in respect of tradable shares, under the 2006 Takeover Regulations the 30 days average trading price is for reference purposes only and is no longer a mandatory minimum price standard. However, if the offer price for tradable shares is less than the 30-day trading average, the financial advisor engaged by the acquirer must provide an analysis of the trading of such shares in the past six months and opine as to whether there has been any manipulation of the share price as well as to the reasonableness of the offer price, etc. 

This new pricing standard will be very advantageous to International Corp. in this hypothetical scenario.  If it stays out of the market for shares of the Target for at least 6 months prior to the deal, then it can negotiate the price for the non-tradable shares with the Seller on strictly commercial terms without reference to net asset value (which is not a preferred pricing methodology in most international M&A deals).  In some cases under the 2002 Takeover Regulations, if (as may commonly be expected to be the case) the net asset value did not match the valuation derived from a more common international valuation methodology (such as a discounted cash flow valuation or multiples of profits based on valuations for other companies in the same industry), foreign acquirers faced significant challenges in satisfying the Chinese legal requirement for approval purposes and persuading their board of directors at home that this was a fair price under the preferred international valuation methodology.

Similarly, so long as International Corp. has not purchased shares of the Target in the 6 months prior to the deal, and so long as its financial advisors can make the required showing noted above as to no manipulation and fairness, its offer price for the tradable shares no longer needs to be tied to the 30-day trading average.  Thus, International Corp. can set a lower offer price for the partial tender offer, which may discourage public shareholders from tendering their shares.

4. PAYMENT, COMPLETION AND ESCROW
In international practice, after all of the various conditions precedent are satisfied or waived, the seller delivers the share certificates and the buyer remits the purchase price to seller's bank account at the same time.  However, in the scenario presented in this case study, under the applicable stock exchange rules as currently in effect, International Corp. would have to pay the full amount of the consideration to the Seller before the non-tradable shares could be transferred to International Corp.  The 2006 Takeover Regulations indicate that the applicable stock exchange rules are to be revised, but it is not clear when this will happen or whether the rule on timing of payment of consideration for shares will be changed.

This creates some headaches for foreign acquirers but it is not fatal, only bothersome.  In order to make this work as practical matter, completion of the acquisition will need to take place in two stages: initial completion whereby International Corp. will first remit the consideration into a special bank account to be opened in the name of the Seller, and then final completion which is to occur upon the completion of the registration of the transfer of shares to International Corp. 

Initial completion marks the time when all principal regulatory and corporate approvals are obtained and all required disclosures and submissions have been made.  These are the most difficult and time-consuming parts of the takeover approval process which could take up to several months.  Final completion is merely a perfunctory compliance procedure in which the Securities Clearinghouse normally does not look into the substance of the transaction.  This final completion stage reportedly takes one to two weeks.

This payment structure also affects escrow arrangements.  Consistent with international practice, International Corp. may intend to retain part of the consideration in an escrow account for a fixed number of years to secure the Seller’s performance of obligations under the SPA.  Such standard arrangement is, however, not possible where the purchase price must be paid in full up front.  (Even if this stock exchange rule on payment timing is changed, the 2006 Cross-border M&A Regulations, which also apply to public company takeovers, generally require the foreign investors to make full payment within three months following registration, and in unusual cases, and subject to receipt of special approvals, no later than one year thereafter, so this also severely undercuts the value of such escrow arrangements.) 

If a standard escrow arrangement cannot be implemented, then International Corp. may choose to investigate an alternative security arrangement: placing a pledge on the legal person shares retained by the Seller.  However, this may also prove to be impractical, due to the complex and virtually unworkable mechanism of enforcement of share pledge in China. In the end, International Corp. may have to consider the use of bank guarantees to take effect on or before initial or final completion.   But this gives rise to separate concerns on the part of the Seller, in respect both of potential cash collateralization requirements to open the bank guarantees as well as the drafting of drawing conditions to ensure that the purchaser cannot simply draw on demand without an objectively verifiable event having occurred.  Consequently, security for the performance of the Seller’s indemnity obligations, while not impossible, is a very complex and difficult matter in China.

5. SHARES AS CONSIDERATION
Use of shares as consideration in share acquisition deals is common in international deals but unprecedented in China as a practical matter.  The 2006 Takeover Regulations contemplate share swaps for the first time but impose certain auditing and valuation requirements, and if the shares offered as payment are not traded on a stock exchange, then cash payment must be provided as an alternative form of consideration.

This is a case in which the regulations may be out in front of the market and perhaps even the regulator, at least in respect of takeovers by foreign acquirers.  Given the relative immaturity of the legal framework for the capital markets in China and the continuing implications of currency controls, we expect that foreign investors will not find it simple or easy to effect a share swap in the near term. 

6. ANTI-TAKEOVER MECHANISMS
The 2006 Takeover Regulations take a more open view of anti-takeover measures.  The Board may take the initiative to propose that the shareholders approve the issuance of new shares or repurchase of existing shares etc. (which was not permitted under the 2002 Takeover Regulations).  Even for matters presumably within the authority of the Board (such as disposal of corporate assets, making of investments, changes to core business of the company, provision of security or incurrence of debt, etc.) which may have a material impact on the assets, debt, interests or operating results of the target company, shareholder consent is still required. 

The 2006 Takeover Regulations also provide that directors of the target company may not resign during the course of a tender offer.  Furthermore, in response to recent efforts to incorporate more aggressive anti-takeover measures into the articles of association of listed companies, the 2006 takeover Regulations expressly provide that the CSRC may order rectification if such measures violate applicable laws.

In any event, such rules likely will not find extensive immediate application as a practical matter since the market conditions are not likely to be conducive for hostile takeovers targeting a majority shareholding interest since the percentage of publicly floated shares in the vast majority of Chinese listed companies does not exceed 30-40% of the total outstanding shares.  (Three years after completion of the share reform program for most Chinese listed companies, more listed companies will have more than 50% of their outstanding shares floated on the exchange, but that still will not guarantee that existing shareholders will agree to sell to a hostile takeover bidder.)

7. CHINESE LAW AND JURISDICTION
The most significant provision relating to foreign investors is Article 4 of the 2006 Takeover Regulations which provides that the transaction documents relating to cross-border public takeovers and related share transfer activities must be subject both to Chinese law (not a new requirement) and also to Chinese domestic courts and arbitration (a novel requirement not seen in connection with any other foreign investment transactions in China).  If the parties do not comply, the CSRC may order the non-compliant foreign acquirer to suspend or terminate its takeover efforts.

This requirement will not be welcomed by foreign investors, but for the most part foreign investors are unlikely to be deterred on this basis alone but will push the envelope to try to obtain the benefits of international arbitration domestically in China.

Looking Ahead

On balance the 2006 Takeover Regulations represent an important step forward for cross-border M&A involving listed company targets in China, but the Chinese regulatory framework is still incomplete and in the near term only the most aggressive of foreign investors will be willing to bear the risks of the attendant uncertainties.  But over time as more Chinese companies list on domestic stock exchanges and the Chinese economy matures to the point that foreign acquisitions seem less threatening to the national economic interests of China, cross-border acquisitions of listed companies in China likely will prove to be an increasingly important market entry and market growth strategy for foreign investors.  And the legal framework will need to continue to develop at a rapid rate to keep pace with the inevitable commercial realities of the most dynamic economy in the world.

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