The outbound acquisition by Chinese investors has become more rational since late 2016 because of the tightened control of the administration of outbound investment through 'window guidance' and uncertainty over the policy. Foreign investment has also been slowed down due to the de facto restriction to the transfer of dividend and investment proceeds out of China and uncertainty over future exit from investment.
However, since 2018, several rules and regulations regarding outbound investment and foreign investment and foreign exchange have been promulgated, with the aim to improve oversight on outbound investment and to facilitate foreign investment in China. Cross-border investment has picked up since the start of 2018.
Domestic and international banks are the primary source of debt finance in acquisition transactions. Finance companies also play an important role in the debt financing market. Unsecured credit facility, secured facility, revolving facility for working capital purposes, bonds and convertible bonds are the most commonly used debt products. Chinese laws are not well developed for the mezzanine finance; however, mezzanine finance is not a new concept in China as it is commonly seen for Chinese companies with an offshore structure. For onshore companies, hybrid debt-plus-securities instruments are commonly arranged, which are more inclined to the hybrid of plain vanilla loans or pure equity solutions.
II REGULATORY AND TAX MATTERS
In China, an entity can only conduct lending business after obtaining the permit or approval by the People's Bank of China, China Banking and Insurance Regulatory Commission (CBIRC) or other competent governmental authorities. Major market players in the debt financing industry are commercial banks, policy-oriented banks, lending companies and micro-lending companies, which should conduct business according to the applicable laws and regulations.
i Acquisition finance
Commercial banks, policy-oriented banks, Chinese branches of foreign banks, finance companies of enterprise groups, while conducting their acquisition finance business, should comply with the Guidelines for Risk Management of Acquisition Financing by Commercial Banks (the Guidelines) promulgated by CBIRC. According to the Guidelines, the financing amount may not exceed 60 per cent of the total acquisition price of a transaction and the term of the loan may not exceed seven years.
According to the Guidelines, a lender conducting acquisition financing business should meet the following requirements: (1) have sound risk management and an efficient internal control mechanism; (2) its capital adequacy ratio is not less than 10 per cent; (3) all of its other regulatory indices meet applicable regulatory requirement; and (4) have a professional team to conduct the due diligence and risk assessment of acquisition financing.
The Guidelines also set forth the requirement for the acquisition financier to maintain the internal control and risk management system, including: (1) its aggregate outstanding amount of acquisition financing not exceeding its net tier-1 capital for the same period, and its aggregate outstanding amount of acquisition financing to a single borrower not exceeding 5 per cent of the net tier-1 capital for the same period; (2) assessing the strategic, legal, regulatory, concentration, business, financial and regulatory risks of an acquisition transaction; (3) reporting to CBIRC the concentration limit on a per-borrower, group customer, industrial, national or jurisdictional basis; (4) ascertaining the leveraged ratio of acquisition financing and ensuring reasonable funding by equity contribution; (5) strengthened due diligence and after lending loan management and supervision; and (6) mandatory provisions in the facility agreement to protect the lender's right, such as the provisions on the lender's right to take risk control measures upon occurrence of material adverse change in the target group and the equity funding as a condition precedent to the disbursement of the acquisition financing.
The Guidelines for Syndicated Loan Business (the Syndication Guidelines) promulgated by CBIRC are the primary regulations on the syndicated loan business, which stipulate the rights and responsibilities of the lead bank, agent bank and participating bank, form of syndication and documentation requirement. If a single bank acts as the lead bank, its commitments should be not less than 20 per cent of the total commitment, and the participating shares of the other members should not be less than 50 per cent of the total commitment.
Anti-money Laundering and anti-corruption compliance
The Anti-Money Laundering Law and the Provisions on Anti-money Laundering of Financial Institutions stipulate the detailed requirement for the financial institutions and certain non-financial institutions to comply with the anti-money laundering obligation, including identifying a client's identity, preservation of information of the clients and transactions and reporting the transactions of large amount or dubious transactions.
In 2017, the People's Bank of China issued a notice to strengthen the scrutiny of identification of a client's identity so as to fight against money laundering and terrorism financing. In the event that the client is a non-individual entity, a financial institution is required to investigate, record and report the current shareholding structure and any change thereof and information on the ultimate parent shareholder and senior management officers. The notice also provides the guidance for strengthening scrutiny if the client is a sensitive individual (e.g., foreign political dignitary, member of senior management of an international organisation or individual beneficially owning the interest of the non-individual client), or is involved in certain type of business relationship (e.g., a client from a high-risk district or countries as identified by FATF, EAG, APG or other international anti-money laundering institutions).
Anti-corruption is largely stipulated in the China's Criminal Law, Unti-unfair Competition Law and related regulations. There is no legislative guidance specifically applicable to the financial institutions regarding administration of anti-corruption matters.
Total interest income is taxable income, and unless otherwise stipulated by law, the taxable income of the enterprises is generally subject to 25 per cent of the corporate income tax in China. The overseas branch office (with no legal person status) of a Chinese resident bank is considered as a resident of China for tax purposes. The income of the overseas branch office is taxable together with its head office, and no withholding tax is payable for the interest paid from a domestic institution to the overseas branch office, provided that, if the overseas branch collects the interest on behalf of a non-Chinese resident, the domestic enterprise is obligated to withhold income tax for the interest paid to the overseas branch. If the actual management organ of a Chinese enterprise's overseas subsidiary is located in China, the overseas subsidiary will be considered as a Chinese resident as well.
Interest expenses are deductible against operating income of the borrower.
The financial institutions are subject to a 6 per cent VAT for the income accrued from the debt financing; if, however, a financial institution is recognised as small-sized taxpayer, the VAT rate is 3 per cent. VAT exemption is granted if the loan is made to small enterprises, micro enterprises or a self-employed household.
Unless otherwise stipulated in the tax treaties or other tax preferential treatment, a Chinese resident borrower should withhold the corporate income tax at the rate of 10 per cent for the interest paid to the non-resident lender.
III SECURITY AND GUARANTEES
The types of security under PRC laws include mortgage, pledge, guarantee and lien, amongst which the security package most commonly used in the acquisition finance transaction are share pledge, cash deposit, corporate or personal guarantee or combination of the foregoing. Mortgage of real estate (including land use right) of great value is also commonly seen, but the practice of registration varies according to different local governmental authorities; mortgages may not be registered in some areas if the beneficiary is non-bank lender.
Grant of cross-border security or guarantee is subject to the administration of the State Administration of Foreign Exchange (SAFE), for example, the provision of guarantee or security by an onshore non-bank entity in favour of an overseas entity securing the debt of an overseas debtor should be registered with SAFE after the execution of security documents.
In the case of listed company takeover, the listed company should not provide any form of financial assistance to the acquirer, or any security in favour of the acquirer or its affiliate.
Security is irrevocable if it is granted within one year of the court accepting a bankruptcy application with respect to the security provider in order to secure an unsecured debt.
IV PRIORITY OF CLAIMS
Secured claims should be repaid in priority from the proceeds of the secured assets. After full repayment of the secured claims, the remaining amount of the proceeds of the secured assets (if any) will be considered as the bankruptcy assets.
Other claims should be paid in the following orders from the bankruptcy assets:
- administrative fees and expenses in connection with the bankruptcy proceeding, and debts incurred for the common good of creditors after initiation of bankruptcy proceeding;
- wages, subsidies for medical treatment, injuries and disability, and the pensions for the disabled and the families of the deceased which the debtor owes, the basic health and pension benefits which should have been paid to the employees' personal accounts, and other compensations should have been paid to the employees as prescribed by law and regulations;
- other social insurance premiums and tax which the bankrupt fails to pay; and
- unsecured bankrupt claims.
In China, subordinated bonds can only be issued by the securities companies and other financial institutions in accordance with law. While Jiangsu High Court recognises the enforceability of a subordination arrangement in a precedent case, contractual subordination arrangements amongst unsecured creditors has a lack of legal basis under the Bankruptcy Law; therefore, it is uncommon to see this in practice.
i Governing law
In a domestic transaction, Chinese law should be the governing law of the transaction agreement. In cross-border transactions, the parties may choose the governing law of the transaction agreements. English law, Hong Kong law and New York law are most often chosen by the parties as the governing law of the cross-border credit facility agreement.
In the absence of a choice of law, the court will apply the rules of closest connection to determine the governing law. For example, the law of the jurisdiction in which the lender is located may govern the financing agreement.
There are some exceptions to the parties' freedom of choice of law. Where the collateral is the immovable asset, the law of the jurisdiction where the immovable assets are located should be the governing law of the security agreement. Chinese law mandatorily applies to certain agreements relating to foreign investment in China, such as, for example, share purchase agreements, assets purchase agreements and subscription agreements involving foreign entities, as well as Sino-foreign equity joint venture contracts, Sino-foreign contractual joint venture contracts and contracts for Sino-foreign joint exploration and development of natural resources that will be performed within China.
Generally, the courts will uphold the choice of law provisions as long as such provisions do not violate public policy of China or contradict the mandatory provisions of Chinese law.
If the court determines that the parties intentionally create the ground to apply foreign law in order to avoid the application of Chinese law, it will not uphold the application of foreign law and Chinese law will apply instead.
ii Recognition of foreign judgment or arbitration award
China is a contracting state of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958).
Where a final and conclusive civil judgment or written order of a foreign court or an arbitral award of a foreign arbitral tribunal is submitted to a Chinese court for recognition and enforcement, it will be reviewed by the court in accordance with the treaty concluded between China and the jurisdiction where the judgment, order or award is made or in accordance with the principle of reciprocity. If the court determines recognition and enforcement does not violate basic principles of Chinese law or is not contrary to the sovereignty, national security or public policy of China, it will recognise the foreign judgment, order or award. In the absence of the treaty or reciprocal relationship, the court will render a ruling to dismiss the application, unless the party concerned applies to the people's court for recognising a legally binding divorce judgment rendered by the foreign court.
VI ACQUISITIONS OF PUBLIC COMPANIES
The Measures on the Administration of Acquisition of Listed Companies (the Acquisition Measures) promulgated by China Securities Regulatory Commission (CSRC) are the major regulations on the acquisition of public companies. Acquisition of listed companies can be taken through agreement or tender offer.
i Mandatory offer requirement
If the shareholding percentage of a purchaser in a listed company does not exceed 30 per cent, and the purchaser wishes to further increase its shareholding percentage therein, it should launch the general or partial tender offer, provided that the shares proposed to be acquired should not be less than 5 per cent of the issued shares of that listed company. If a purchaser holding more than 30 per cent of the issued shares of a listed company wishes to further increase its shareholding percentage, it should launch the general tender offer to acquire all the shares of the target company. The purchaser may apply to CSRC for waiving the foregoing tender offer or general tender offer requirement.
ii Disclosure of the financing terms
The tender offer report should, amongst others, disclose the financing arrangement. However, the detailed terms, including the flex and fees, are not required to be disclosed.
The purchaser is not entitled to squeeze out the minority shareholders.
In the event of a general tender offer, the purchaser is required to specify in the offer report, amongst other things, the closing date after delisting and arrangements for the shares held by the remaining shareholders after expiration of the offer period. If, at the end of the offer period, the target company fails to meet the listing requirement (i.e., less than 25 per cent of the shares are held by the public, or in the case of the total value of the shares of the target exceeding 400 million yuan, less than 10 per cent of shares are held by the public), the target company should be delisted. If requested by the remaining shareholders, the purchaser should purchase the shares then held by the remaining shareholders within the timeline as provided in the purchaser's offer report on the same terms as the tender offer.
In the event of a tender offer, the purchaser should firstly prepare the offer report and disclose the summary of the offer report in a brief announcement. All the conditions to the offer shall be highlighted in the summary of the report. The offer report will be disclosed after the conditions have been satisfied. Unless otherwise waived by CSRC, the offer report is unconditional.
Chinese law currently does not stipulate the requirement of the conditionality to the offer. Obtainment of the governmental approval is commonly seen as condition in the summary of the offer. There are cases where satisfaction to the due diligence result by the purchaser is the condition in the summary of the offer.
iv Form of payment
The purchaser may, by means of cash, securities, or combination of cash and securities, or by other lawful means, pay the purchase price for acquisition of a listed company. In the case of payment in securities, the purchaser should provide audited financial and accounting statements, and securities evaluation report of the issuer of the said securities for the last three years, and should cooperate with the independent financial adviser engaged by the target company in its due diligence investigations. In the case of payment in transferable bonds, the bonds must have been listed in the securities exchange for at least one month. In the case of payment in securities that are not listed in any securities exchange, the purchaser must meanwhile provide the cash payment option for the offerees to choose.
In the case of general tender offer to acquire all the shares of the target company, the consideration should be paid in cash. If the purchaser wishes to pay the consideration by transferable securities, it must, at the same time, also offer the cash payment option for the offerees to choose.
v Certain funds requirement
The purchaser should provide at least one of the following measures to guarantee the performance:
- in the case of payment of the purchase price in cash, a deposit of not less than 20 per cent of the total consideration to the designated account of securities depository and clearing institution; in the case of payment of purchase price in securities, a deposit equalling the value of all the securities used for payment in the custody of the securities depository and clearing institutions;
- a bank guarantee covering the total purchase price;
- a written commitment issued by the financial adviser undertaking joint and several liability for payment of consideration.
The financial adviser of the purchase is also required to conduct due diligence on the purchase's capability and source of funds, and to specify whether the purchaser has the ability to complete the tender offer in its report and whether there is any circumstance where the purchaser obtains the financing by way of mortgaging the target shares.
VII THE YEAR IN REVIEW
A series of rules in relation to the outbound investment have been promulgated in the past year, including the Administrative Measures on Enterprise Outbound Investment and the Catalogue of Sensitive Industries for Overseas Investment (2018 Edition) promulgated by the National Development and Reform Commission, which replace the regulatory procedure for a Chinese enterprise to invest overseas, including streamlining the supervision methods, expanding the scope of covered transactions, redefining sensitive industry and strengthening post-completion supervision. The new rules and measures impose more comprehensive requirements and clearer guidelines for overseas investment.
On the other hand, the Chinese market has been continuing to open up to foreign investment, and various measures have been taken to streamline the administration. In the banking sector, CBIRC issued a set of rules to further relax market access to foreign banks, including removing the caps on foreign ownership in Chinese banks and financial asset management companies, applying non-discriminatory ownership limit rules, broadening the business scope of foreign banks and allowing for wider commercial presence choice of foreign banks.
From January to August 2018, comparing to the same period of 2017, the total foreign investment amount increased by 2.3 per cent, the number of newly incorporated foreign invested companies increased by 102.7 per cent and the overseas investment amount in the non-financial sector made by Chinese enterprises increased by 7.7 per cent.2
In terms of debt finance, debt finance in the real estate sector fell notably owing to the enhanced scrutiny. On 29 January 2018, the Shanghai bureau of CBIRC issued a notice regulating finance for the purpose of acquisition of shares of the real estate companies (the Notice). The Notice establishes the principle of penetrating supervision for the financing of the acquisition of shares in real estate development enterprises and strengthens the supervision of acquisition of real estate development. The Notice prohibits acquisition finance being raised for payment of land acquisition consideration and requires that acquisition financing involving acquisition of land can only be provided until and after 25 per cent of the total investment amount of the project has been used.
The current Company Law is expected to be amended next year. On 6 September 2018, the Amendment to Company Law (Draft for Comments) was released for comments, pursuant to which, more repurchase events are to be added, including repurchasing the shares by a listed company for the purpose of converting the shares in cooperation of issuance of convertible bonds and warranties, and repurchasing of shares by the listed company that is necessary to maintain the credit of the listed company and interest of the shareholders. The amendment of China's Securities Law, which was intended to take effect in 2018, has now been postponed to 2020. The proposed amendment calls for the replacement of the current examination and approval-based system for IPOs with a registration-based system.
Although 2017 saw a slight decline in the cross-border investment – and Chinese investment in US has been hindered because of the enhanced scrutiny on Chinese investment in US firms by the Committee on Foreign Investment in the United States (i.e., CFIUS) since 2018, the long-term trend of Chinese companies to invest overseas will continue, especially in the sectors of infrastructure, agriculture, energy and resources, high-tech and services that are in line with the Belt and Road Initiative, while investment in the sectors of real estate, entertainment, sports club, cinemas, hotels and investment platforms will continue to be restricted.
More measures are also expected to be issued to facilitate foreign investment and relax market access restrictions.
In terms of debt financing, while the Notice now only applies to the financial institutions and finance companies in Shanghai, it is expected that similar rules will be promulgated in other regions or even nationwide. The supervision over financing in the real estate sector will continue to be tightened.
1 Xiong Yin, Jie Chai are senior partners and Qin Ma is a senior associate at Tian Yuan Law Firm.