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, under which companies can issue securities backed by credit assets consisting of the debts arising out of a number of loans of multiple borrowers in the national inter-bank bond market or stock exchanges, and the qualified investors thus may be able to negotiate and trade such securities. Information regarding debts in the asset pool of the securities should be disclosed, including the names of the borrowers and the loan agreements.
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 the 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.
ii Syndicated loan
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.
iii 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 large-amount transactions 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 China's Criminal Law, Anti-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, among 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 a 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 that the debtor owes, the basic health and pension benefits that should have been paid to the employees' personal accounts, and other compensations that should have been paid to the employees as prescribed by law and regulations;
- other social insurance premiums and tax that 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 among unsecured creditors have 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 the 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 the CSRC to waive the foregoing tender offer or general tender offer requirement.
ii Disclosure of the financing terms
The tender offer report should, among other things, disclose the financing arrangement. However, detailed terms, including the flex and fees, are not required to be disclosed.
There are no squeeze-out rules in China. However, in the case of a general tender offer, the purchaser is required to specify in the offer report, among 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 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 case of a tender offer, the purchaser should first prepare the offer report and disclose the summary of the offer report in a brief announcement. All the conditions to the offer should be highlighted in the summary of the report. The offer report will be disclosed after the conditions have been satisfied. Unless otherwise waived by the 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 a 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.
v 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 a securities evaluation report of the issuer of the said securities for the past 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 a 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, offer the cash payment option for the offerees to choose.
vi 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; and
- a written commitment issued by the financial adviser undertaking joint and several liability for payment of consideration.
The financial adviser of the purchaser is also required to conduct due diligence on the purchaser'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
Owing to the trade frictions between China and the United States and the enhanced scrutiny on Chinese investment in US firms by the Committee on Foreign Investment in the United States, Chinese investment in the United States has dropped since 2018, from a peak of US$46.5 billion in 2016 to just US$5.4 billion in 2018.2 While China's global outbound investment surged in 2018 and was broadly flat in the first half of 2019, it was led by technology, media and telecommunication (TMT), life sciences and mining and metals. TMT remains the most attractive sector to Chinese investors by number of deals.
On the other hand, foreign direct investment into China rose 3.6 per cent year-on-year to US$78.8 billion in January to July 2019, or 7.3 per cent to ¥533.14 billion.3 This was driven by the continuing opening-up of Chinese market. A new Foreign Investment Law (the New FDI Law) was promulgated on 15 March 2019 and will come into effect on 1 January 2020, replacing the existing three laws on foreign investment (i.e., the Law on Sino-Foreign Equity Joint Ventures, the Law on Sino-Foreign Contractual Joint Ventures and the Law on Wholly Foreign Owned Enterprises – collectively, the Existing FDI Laws). The New FDI Law is considered as an effort of the Chinese authorities to address foreign concern and criticism on Chinese openness, by, for example, pledging to grant equal treatment to foreign investors as that to their domestic counterparts, access to public procurement, prohibiting infringement of intellectual property rights and trade secrets, and barring Chinese authorities from forcing technology transfer. Furthermore, the New FDI Law will ease restrictions on those industries that were not accessible to foreigners.
The 2019 editions of the Negative List and Encouraged List for foreign investment, jointly promulgated by the National Development and Reform Commission and the Ministry of Commerce on 31 June 2019, are important supplements to the New FDI Laws. In contrast to the 2018 versions, there are fewer sectors where foreign investment is restricted (e.g., allowing foreign investors to have controlling interest in exploration and development of certain types of oil and natural gas, construction and operation of cinemas, domestic shipping agents), and more sectors have been added to the encouraged sectors for foreign investment. Foreign investment in encouraged sectors will be eligible for preferential treatment (e.g., tax, land prices). Foreign-funded projects in sectors not falling under both lists will enjoy national treatment.
Furthermore, according to a guideline jointly released by the National Development and Reform Commission, the People's Bank of China, the Ministry of Finance and the China Banking and Insurance Regulatory Commission, the Chinese government will step up efforts to support financial institutions to conduct market-oriented debt-for-equity swaps on qualified enterprises, with the aim of reducing high corporate leverage to resolve debt risks for private business, and to boost the growth of private economy.
To respond to the New FDI Law, it is expected that the Chinese government will introduce a series of implementing regulations and directives to protect the rights and interests of foreign investors in the foreseeable future. Foreign investment in China will continue to be boosted, driven by the relaxation of market access.
However, the long-term trend of Chinese companies investing 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.
Various measures will also be unveiled to lower enterprise leverage and handle the debt issues of 'zombie companies' and to optimise the safeguard mechanism for bankruptcy; for example, the government will encourage commercial banks to set up financial asset investment subsidiaries to accelerate debt-for-equity swaps, and will allow financial institutions to raise capital by selling asset management products to invest in debt-for-equity programmes. Private capital will also be encouraged to participate.
1 Xiong Yin and Jie Chai are senior partners and Qin Ma is a senior associate at Tian Yuan Law Firm.