After achieving its best all-around year in 2017, private equity activity in China started to slow down in 2018, signalling the commencement of a new cycle of market development. In 2018, private equity investments in China decreased from the peak of 2017, in terms of both volume of investments and value of investments, but still ranked as the second highest on record by both measures. According to AVCJ Research, the market research division of the Asian Venture Capital Journal, based on its data as at 22 January 2019, there were 1,668 private equity investments (of which 793 were publicly disclosed) with an aggregate investment amount of US$91.75 billion in China in 2018. Compared with 1,823 investments with an aggregate amount invested of US$100.48 billion in 2017, the total volume of investments decreased by 8.5 per cent and the total value of investments decreased by 8.7 per cent in 2018. China was still the most active private equity market in Asia and contributed approximately 50 per cent of the total value of the private equity investments in the Asia-Pacific region in 2018.
The distribution among different investment types in 2018, compared with that in 2017, exhibited a further uptick in expansion and growth-stage investments, and a drop in start-up and early-stage investments, along with a significant decline in buyout investments (including management buyout, management buy-in, leverage buyout and turnaround or restructuring stages). According to AVCJ Research, investments at expansion and growth stages stayed ahead of other investment stages, at US$74.85 billion or 81.58 per cent of total investment value in 2018, up from US$68.63 billion or 68.30 per cent in 2017; investments in the start-up and early stages represented a smaller proportion of total investment value in 2018 than in 2017, dropping from US$18.11 billion or 18.02 per cent of total investment value in 2017 to US$13.62 billion or 14.84 per cent of total investment value in 2018; and buyouts declined significantly, from US$13.74 billion or 13.67 per cent of total investment value in 2017 to US$3.29 billion or 3.59 per cent of total investment value in 2018.
The significant decline in private equity buyouts in 2018 was particularly noteworthy given the overall trend in that space since 2010. While traditionally buyouts in China have remained relatively less frequent in comparison with many other jurisdictions, buyout activities experienced an uptick in 2010 and 2011, further strengthened in 2012 to 2014 amid growing popularity of going-private transactions involving China-based companies, particularly companies listed in the United States, and boomed to be the bandwagon in 2015 as many US-listed Chinese companies received going-private proposals at the prospect of seeking future listing on China's A-share market or the Hong Kong Stock Exchange. After experiencing a decline in 2016 and a short recovery in 2017, buyout activities in China hit a record low in 2018, and going-private activities were almost suspended. Based on statistics obtained through searches on the Thomson Reuters database Thomson ONE, of the 209 going-private transactions announced since 2010, 43 did not proceed (18 of which involved private equity sponsors) and 135 have closed (five closed in 2010, 13 in 2011, 19 in 2012, 18 in 2013, 25 in 2014, 16 in 2015, 24 in 2016, 14 in 2017 and 1 in 2018). As of 31 December 2018, 29 going-private transactions were pending, including three announced in 2012, one announced in 2013, two announced in 2014, five announced in 2015, six announced in 2016, seven announced in 2017 and five announced in 2018. Of the 135 completed going-private transactions, 39 involved private equity sponsors, and of the 29 pending going-private transactions, nine involved private equity sponsors.
In respect of exits via initial public offerings (IPOs), China undertook the longest moratorium on A-share IPOs in its history from November 2012 to December 2013, and imposed another four-month moratorium on A-share IPOs in 2015. Following a strong recovery with a record number of successful IPOs in the Chinese domestic IPO market in 2016 and early 2017, the number of Chinese domestic IPOs dropped significantly at the end of 2017 until the second half of 2018 on account of tightened review standards, and a large number of IPO applications were queued. In part as a result of this large backlog, private equity-backed IPOs, an exit route heavily depended on by China-focused private equity funds, exhibited a further uptick in the second half of 2018, with an 11.4 per cent increase in terms of funds raised in such IPOs and a 109 per cent increase in terms of deal value compared with 2017, according to AVCJ Research. Exits via trade sales and secondary sales, accounting for 77.1 and 5.1 per cent, respectively, of private equity-backed exits in 2017, and 84.6 and 9.8 per cent, respectively, in 2018, according to AVCJ Research, remained the dominant exit route for private equity funds in 2018 and they are likely to maintain this position in the foreseeable future.
In 2018, Chinese outbound M&A deal activity declined from the record-hitting level seen in 2016. This was partially because of heightened scrutiny over these transactions by the United States and certain European countries, and also because Chinese regulators have promulgated guidelines and policies on foreign exchange outflow control, and on the outbound target industries and channels for onshore financing affecting outbound investment activities, and have encouraged a more strategic and prudent approach in Chinese outbound investments. According to AVCJ Research, in 2018, financial investor-backed Chinese outbound investments generally maintained the level of activity seen in 2017 in terms of number of announced deals, with 139 deals announced in 2018 and 134 announced in 2017, while the announced deal value declined by 32 per cent compared with deal value in 2017.
II REGULATORY FRAMEWORK
i Investments through acquisition of control and minority interests
China's current Companies Law, which became effective on 1 January 2006 and was amended in 2013 and 2018 with effect from 26 October 2018, sets out the governance framework for the two types of Chinese companies: companies limited by shares (CLSs) and limited liability companies (LLCs). A Chinese entity in which a non-Chinese investor owns an equity interest is called a foreign-invested enterprise (FIE), of which there are several types, including a wholly foreign-owned enterprise (WFOE), an equity or cooperative joint venture, and a foreign-invested company limited by shares (FICLS). FIEs are subject to separate statutes in addition to the Companies Law, including the Law on Wholly Foreign-Owned Enterprises (which applies to WFOEs), the Law on Sino-Foreign Equity Joint Ventures and the Law on Sino-Foreign Cooperative Joint Ventures (which respectively apply to the two types of joint ventures), and the Interim Provisions on the Establishment of Foreign Invested Companies Limited by Shares (which applies to an FICLS), including in each case their respective implementation rules. The Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the M&A Rules), jointly issued by six governmental agencies in 2006 and amended in 2009, establish a general legal framework under which non-Chinese investors can acquire the equity or assets of a Chinese company subject to regulatory approvals. However, through a series of amendments to various company laws in 2016, 2017 and 2018, the regulatory approvals established by the M&A Rules are in practice no longer required, and instead there is a record-filing regime for FIEs in place. This record-filing regime (for certain FIE matters, including incorporation and certain corporate governance changes of FIEs) was established on 8 October 2016 by the central Ministry of Commerce (MOFCOM). On 30 July 2017, MOFCOM promulgated an amendment to further expand the record-filing regime to cover general mergers and acquisitions by foreign investors, provided that the transaction does not trigger 'special management measures for foreign investment access' under the Special Administrative Measures (Negative List) for the Access of Foreign Investment (the Foreign Investment Negative List) (as discussed below), pursuant to which the original approval regime under the M&A Rules was, in practice, substantially replaced by the record-filing regime. On 30 June 2018, MOFCOM further amended the record-filing rules to simplify the regulatory procedures applicable to FIEs. Under the new regime stipulated in the 2018 amendment, the filing with MOFCOM will be integrated as part of the regular registration procedure before the State Administration of Market Regulation (SAMR, the company registry agency that records all corporate registration information of legal entities incorporated under Chinese laws, whether domestic companies or FIEs), and after the filing has been submitted, to SAMR only, SAMR will forward the relevant information to MOFCOM for it to complete its filing procedure. The FIEs therefore will enjoy, in general, the same treatment in terms of governmental filing procedures as Chinese domestic companies (except where transactions fall within the scope of the Foreign Investment Negative List). However, to date, this new filing regime has yet to be implemented in practice. There are also other statutes and rules governing transfers of equity, mergers and other transactions involving FIEs.2
On 19 January 2015, MOFCOM released a draft of the proposed new Foreign Investment Law (the Draft FIL) for public comment. The Draft FIL proposes sweeping reforms to the current Chinese foreign investment legal regime by removing many distinctions between FIEs and Chinese domestic entities and streamlining the oversight of foreign investments, while raising substantial uncertainty as well. If the Draft FIL were to be formally promulgated as it is, without major changes to its terms and provisions, the Law on Wholly Foreign-Owned Enterprises, the Law on Sino-Foreign Equity Joint Ventures and the Law on Sino-Foreign Cooperative Joint Ventures would probably be repealed, while other statutes and rules on foreign investments would require amendments to adapt to the new regime. However, at the time of writing, the Draft FIL has not been submitted to the National People's Congress for a vote. On 26 December 2018, the Standing Committee of the National People's Congress released a high-level summary of the updated draft of the Foreign Investment Law (the Updated Draft FIL) for public comment (from 26 December 2018 to 24 February 2019). The Updated Draft FIL is generally in line with the Draft FIL inasmuch as the proposed Foreign Investment Law would replace the Law on Wholly Foreign-Owned Enterprises, the Law on Sino-Foreign Equity Joint Ventures and the Law on Sino-Foreign Cooperative Joint Ventures. Subject to the discretion of the Standing Committee of the National People's Congress, the Updated Draft FIL may be submitted to the National People's Congress for a vote during its annual meeting in March 2019, and will be further promulgated upon an affirmative approval by the National People's Congress.
Regulatory regimes applicable to foreign investments
An acquisition of or investment in a Chinese company by a non-Chinese investor is subject to a multilayered government approval, filing and registration process. Subject to the recent developments in respect of the record-filing regime applicable to FIEs (see Section IV.i), the highest level of scrutiny is applicable to onshore investments (that is, direct acquisitions of equity in Chinese companies), which require the applicable project-based approval of the National Development and Reform Commission (NDRC) or its local counterpart, and the approval by, or filing with, central MOFCOM if the size of a greenfield investment or the total investment amount of a target company whose business is in the industries specified in the Foreign Investment Negative List (as discussed below) exceeds US$1 billion, or MOFCOM's local counterpart if the size of the investment falls below US$1 billion but the target's business still falls within the industries specified in the Foreign Investment Negative List. Approval at the local level can typically be obtained within one month, but approval from central MOFCOM and the NDRC often takes several months or longer. If a transaction is subject to an antitrust or national security review, as discussed below, MOFCOM or its local counterpart will typically defer review until the antitrust or national security reviews are completed.
Whether MOFCOM and the NDRC will grant approval for a transaction depends in part on whether the type of the underlying acquisition target falls within the scope of the Foreign Investment Negative List, jointly published by MOFCOM and the NDRC in 2018, which lists the industries where special management measures for foreign investment access are applicable. The Foreign Investment Negative List partially replaces the former Catalogue for the Guidance of Foreign Investment Industries (the Foreign Investment Catalogue), and instead of grouping industries for foreign investment into 'encouraged', 'prohibited' and 'restricted' categories as the Foreign Investment Catalogue did, the Foreign Investment Negative List specifies only two categories of industry: industries in which foreign investment is prohibited and industries in which foreign investment is allowed, with certain restrictions. Industries not mentioned by the Foreign Investment Negative List are deemed 'permitted' (i.e., not subject to the special management measures for foreign investment access). As there is no mention of the category in the Foreign Investment Negative List, the list of industries encouraged in the 2017 version of the Foreign Investment Catalogue remains effective. While a non-Chinese investor can acquire full ownership of a company in most encouraged and permitted sectors (and is often entitled to special advantages compared to domestic investors when acquiring a company in an encouraged sector), to invest in most sectors subject to the special management measures for foreign investment access (i.e., restricted industries), a non-Chinese investor is required to team up with a Chinese partner (and, in some cases, the Chinese partner must maintain a controlling stake). Investments by a non-Chinese party in a prohibited sector are typically prohibited.
In addition to these general approval requirements, foreign investments in several industries, such as construction and telecommunications, are subject to approval from the relevant Chinese regulatory authorities governing the applicable industries.
An indirect investment in China by way of an investment in an offshore holding company that owns equity of a Chinese FIE is not subject to the MOFCOM and NDRC approvals applicable to an onshore investment; however, both an onshore and an offshore investment may be subject to China's antitrust and national security review schemes.
The antitrust regime in China is established and governed the Anti-Monopoly Law of the People's Republic of China (AML), which became effective on 1 August 2008. Under the AML, an antitrust filing with the SAMR anti-monopoly authority is required for any transaction involving a change of control if the sales in China in the prior accounting year of each of at least two of the parties exceeded 400 million yuan, and either party's aggregate worldwide sales in the prior accounting year exceeded 10 billion yuan or the parties' aggregate sales in China in the prior accounting year exceeded 2 billion yuan. These monetary thresholds will remain unchanged until new ones are promulgated in an amendment to the AML; to date, there has been no amendment to these thresholds since 2008. According to MOFCOM's 2017 annual review relating to the AML, throughout 2017, MOFCOM received 400 merger notifications (5.8 per cent more than in 2016) and closed 344 cases (12.9 per cent less than in 2016), among which MOFCOM imposed conditions on seven transactions (compared with two in 2016), including Dow Chemical and DuPont, Broadcom's purchase of Brocade, HP's purchase of Samsung's printer business, the merger of Agrium and Potash Corp of Saskatchewan, ASE's purchase of SPIL, Maersk Line's acquisition of Hamburg Sud and Becton Dickinson's acquisition of CR Bard. The number of MOFCOM conditional merger approvals in one year has hit a record high since the AML was promulgated. In 2017, MOFCOM imposed fines on six transactions for failure to comply with the merger notification requirements (including Canon's acquisition of Toshiba Medical Systems Corporation and Meinian Onehealth Healthcare's acquisition of Ciming Health Checkup, which were fined for gun-jumping in structured multi-staged transactions), which were the 14th to 19th AML penalty decisions published by MOFCOM. With the establishment of SAMR in 2018, and following internal adjustment of the scope of supervision within the Chinese government, as from mid 2018, all AML filings are to be made to SAMR instead of MOFCOM. Given this change of regulatory body in relation to antitrust filings, there are as yet no relevant statistics for 2018, from either MOFCOM or SAMR.
In February 2011, China's State Council issued Circular 6, which established a national security review scheme for the acquisition of a Chinese business by one or more non-Chinese investors. Two broad transaction types are subject to Circular 6 review:
- the 'acquisition' of any stake (regardless of the size) in a military enterprise, a supplier to a military enterprise, a company located near sensitive military facilities or any other company relating to national defence; and
- the acquisition involving 'control' of a Chinese company whose business involves 'key' agricultural products, energy and resources, infrastructure, transportation services or technologies or manufacturing of equipment and machinery 'affecting national security'.
In April 2015, the General Office of the State Council issued the Tentative Measures for the National Security Review of Foreign Investment in Pilot Free Trade Zones (FTZs), which took effect in May 2015 (the Tentative Measures). Under the Tentative Measures, the national security review extends to foreign investment in important culture and information technology products sectors that are vital to national security and in which foreign investors have de facto control over the invested entities. The types of foreign investments regulated by these Tentative Measures include sole proprietorship, joint venture, equity or asset acquisition, control by contractual arrangements, nominal holding of interests, trust, re-investment, offshore transactions, leasehold and subscription of convertible bonds. The Draft FIL has attempted to codify the national security review as part of the foreign investment review regime, and seeks to broaden the scope of review by expressly allowing all types of foreign investments (not limited to acquisitions) to trigger the review and expanding the list of factors that can be taken into account in the review.
Both China's antitrust and national security review schemes provide Chinese authorities with wide discretion to determine whether a transaction is subject to review or, if subject to review, whether it should be blocked. Under Circular 6, the meanings of 'key' and 'affecting national security' are undefined. Provisions issued by MOFCOM in 2011 to implement Circular 6 prohibit an investor from circumventing the national security review by structuring a transaction by way of nominee arrangement, trust, multilayered re-investment, lease, loan, contractual control, offshore transaction or other such structuring. Under both the AML and Circular 6 and other regulations regarding antitrust or national security review, control is defined broadly and includes having voting rights sufficient to exercise a major impact on board or shareholder resolutions, particularly with respect to key business or operational decisions. As such, private equity investments involving certain customary protections (e.g., veto rights, supermajority voting requirements, negative covenants) arguably could be interpreted to involve control under both statutes. If there is ambiguity as to whether a filing is required, it is usually prudent for an investor to make a filing to avoid adverse consequences later. After SAMR was established and assumed responsibility for antitrust filing matters, the State Council issued revised guidelines on antitrust filings in September 2018, which are not substantially different from the original guidelines and have simply changed the relevant regulatory authority's name and where the relevant party should submit the filing. Prior to this 2018 version, the 2014 revised guidelines attempted to clarify the moderately controversial concept of control in the context of antitrust filings and provided for a formal pre-filing consultation with the Anti-Monopoly Bureau of MOFCOM (changed to the Anti-Monopoly Bureau of the State Administration of Market Regulation in the 2018 guidelines) for investors, to assist them in determining whether a filing would be triggered. If a transaction is subject to national security or antitrust review, the anti-monopoly authority will conduct a policy-driven review to determine whether the transaction can proceed unimpeded: it considers not only the effect of a transaction on national security or competition, as applicable, but also takes into account its effect on public interest and the stability of the national economy and social order, as well as the views of industry associations and other market participants.
Further, the M&A Rules contain, in effect, a restriction on 'round-trip' investments by requiring MOFCOM approval for any acquisition of a Chinese company by an offshore company formed or controlled by any Chinese entity or individual affiliated with the Chinese target company. Typically, this approval is not granted. Where the offshore structure was in place prior to the adoption of the M&A Rules in 2006, however, the acquisition of a Chinese target by the offshore entity may still be permitted.
In contrast, the Draft FIL is proposing a shift from the current case-by-case approval regime for all foreign direct investments to a refined regime, namely an 'entry clearance review', applicable only to foreign investments in restricted sectors on the Foreign Investment Negative List. However, if the Draft FIL materialises and the concept of 'de facto control' is adopted by MOFCOM in determining whether an entity will be treated as an FIE or a Chinese domestic entity and assessing whether certain foreign investors may participate in those sectors on the Foreign Investment Negative List, certain types of indirect investments may unprecedentedly come within the purview of Chinese regulators. Notwithstanding this, given that the Draft FIL has been updated a few times and the Updated Draft FIL is still under review, it is not clear whether this proposal will become reality, or what the details of the applicable rules would be.
Governance of and exit from onshore joint ventures
The Chinese corporate law and regulatory framework applying to FIEs make it difficult for shareholders in a Chinese company to obtain or enforce certain contractual rights that are considered fundamental for private equity investors in other jurisdictions, including rights pertaining to governance and exit. First, members of an onshore equity joint venture have rights of proportional representation on the board, meaning that a Chinese partner typically has the right to appoint at least one director. Further, certain important corporate acts of any joint venture must be unanimously approved by the board, including:
- any amendment to the articles of association (which is required in connection with any equity transfer);
- any liquidation or dissolution;
- any increase or decrease in registered capital; and
- any merger or division.
As a result, a non-Chinese investor with a majority stake in a joint venture cannot obtain complete control because the minority partner has statutory veto rights via its representative on the board.
Moreover, it may be difficult for a non-Chinese investor to enforce certain exit-related provisions that are often key terms of a private equity investment. Transfers of equity in an onshore joint venture are subject to a statutory consent right and right of first refusal by all other members. Theoretically, these rights can be waived in advance in the joint venture contract. In practice, however, a transfer of a shareholder's interest in a Chinese joint venture requires amendments to the joint venture contract and articles of association as well as the filing at both MOFCOM or its local counterpart and SAMR or its local counterpart. Because an amended joint venture contract (which MOFCOM expects to review to approve a transfer) requires signatures from all shareholders, the other shareholders' cooperation is necessary in connection with any transfer. The same difficulties arise for a private equity investor seeking to enforce a call right, put right or drag-along right against the Chinese shareholders (a tag-along right is easier to enforce, as the party with the tag right can attempt to block a transfer if the transferor fails to comply with the other shareholders' tag-along right). If the Chinese shareholder is a state-owned enterprise (SOE), enforcement is even more difficult, as a transfer of an SOE's interest in a joint venture is subject to a statutory appraisal and an open bidding procedure, unless waived by the appropriate authorities. Regardless of what rights may be contained in a joint venture contract, a local Chinese court injunction granting specific performance against a Chinese shareholder and in favour of a foreign investor is far from certain.
Implications of the regulatory framework on a transaction structure
To avoid the requirements of obtaining NDRC and MOFCOM approval and to enhance structuring flexibility, foreign private equity investors typically prefer to invest in China through an offshore investment. The ideal transaction structure, when feasible, is for the foreign investor to invest alongside a Chinese partner in an offshore Cayman Islands or British Virgin Islands company, with the company owning 100 per cent of a Chinese WFOE (often indirectly through a Hong Kong entity, to obtain preferential treatment on dividends). This structure also allows the foreign investor to benefit from transaction agreements governed by foreign law and to avoid the need to enforce its rights in China. Because of foreign ownership limitations and the prohibition on round-trip investments, however, this offshore structure is seldom available for foreign investments in Chinese targets that have not formed an offshore holding structure prior to the effectiveness of the M&A Rules.
Many non-Chinese investors use a 'variable interest entity' (VIE) structure to invest (indirectly) in China to avoid seeking certain Chinese regulatory approvals (approvals that will not or will not be expected to be granted to FIEs). Under a VIE structure, Chinese individuals, often the founders, key management members or their relatives, are the registered shareholders of a domestic operating company, which holds the required licences and permits needed for the business to operate. An investor (often in conjunction with the founders) then forms a WFOE through an offshore entity it owns, and the WFOE enters into a series of contractual arrangements with the operating company and its registered shareholders pursuant to which the WFOE obtains control and an economic interest in the operating company. These contractual arrangements can take many forms, but often include an exclusive service or licence agreement, a voting proxy agreement, a share pledge agreement and a loan agreement, and an exclusive option agreement (together with a form of equity transfer agreement) allowing the WFOE (when permitted by Chinese law) or its appropriate affiliates or designees to acquire the equity interests or assets of the operating company. Commentators frequently note that the VIE structure is legally risky given that it arguably violates the spirit (if not the letter) of Chinese regulations; however, Chinese companies, including some of the large public companies, such as Alibaba, Baidu and Tencent, continue to use this structure.
There is speculation that the Draft FIL may address and provide explicit rules on the use of the VIE structure. However, as noted above, as the Draft FIL has been updated several times and the Updated Draft FIL is still under review, the details of these rules or whether they will actually materialise remains unclear.
ii Fiduciary duties and liability
Fiduciary duties and potential liabilities of directors, officers and supervisors under Chinese law
The Companies Law is the primary statute regulating the actions and duties of directors, officers and supervisors of a Chinese company. Pursuant to the Companies Law, a director, officer or supervisor must abide by the laws, administrative regulations and articles of association of the company, and has duties of loyalty and care to the company. As in many other countries, a breach of duty may give rise to civil, administrative or criminal liability. A particular concern to a private equity investor in China, however, is that a director, officer or supervisor may be liable for criminal liability not only for his or her own wrongdoing, but also for crimes committed by the company if he or she is the 'manager directly in charge' or 'person directly responsible' for the management of the matter with respect to which a specific criminal act was committed by the company. This risk of personal liability for company wrongdoing is more acute for a director or officer who is also the chair of the board, executive director or legal representative of the company or who otherwise serves in a senior management capacity, such as a general manager or chief financial officer. Often by way of seeking to ensure that their representatives are not assigned responsibility for any specific matters, most non-Chinese private equity funds are comfortable appointing their representatives to the boards of Chinese companies, despite the risk of liability. While directors' and officers' insurance and indemnification agreements may protect against civil liability, many types of administrative or criminal liability cannot be mitigated with insurance and indemnification.
Chinese tax exposure
Since January 2008, China's Enterprise Income Tax Law (EIT Law) has imposed a 10 per cent capital gains tax on the sale of a domestic Chinese company by a foreign investor. On 3 February 2015, the State Administration of Taxation of the People's Republic of China (PRC) issued Circular (2015) No. 7 (Circular 7) on Chinese corporate income tax treatments of indirect transfers of Chinese assets (including equity interest in a Chinese company) by non-resident enterprises. Under Circular 7, an indirect equity transfer of a Chinese entity by an offshore seller (such as selling the equity of an offshore holding company) that does not have a reasonable commercial purpose and that is structured to avoid applicable Chinese taxes will be recharacterised by the Chinese tax authorities as a direct equity transfer of the Chinese entity for Chinese tax purposes, and the offshore seller will be required to pay capital gains tax for the transaction. Although it is within the discretion of the parties to such offshore transactions to determine whether to make a Circular 7 filing to report the offshore transaction for the Chinese tax authorities' assessment for Chinese tax purposes, Circular 7 employs a penalty structure designed to motivate parties to offshore transactions involving indirect sales of Chinese companies to report potentially taxable transactions to the Chinese tax authorities. Because of the uncertainty under the Circular 7 regime regarding what will satisfy the Chinese tax authorities as a non-tax-avoidance justification with reasonable commercial purpose for the offshore sale of Chinese entities, and regarding the evolving market practice with respect to these matters, many practitioners interpret the application of Circular 7 in a broad way and recommend making Circular 7 filings to reduce the risks and potential penalties for evading Chinese tax obligations.
An offshore vehicle established by a non-Chinese private equity investor to make an investment in a Chinese company will be treated as a 'PRC-resident enterprise' under the EIT Law, and will be subject to a uniform 25 per cent enterprise income tax on its worldwide income where the offshore vehicle's de facto management body is in China. Although the law is unclear, factors that the State Administration of Taxation may take into account in determining tax residency include whether:
- the offshore vehicle locates its senior management and core management departments in charge of daily operations in China;
- financial and human resources decisions of the offshore vehicle are subject to determination or approval by individuals or bodies in China;
- the offshore vehicle's major assets, accounting books, company seals, and minutes and files of board and shareholders' meetings, are kept or located in China; and
- at least half of the offshore vehicle's directors or senior management reside in China.
To mitigate the risk that any dividends, sale proceeds or other income received by an offshore vehicle might be subject to this tax, an offshore vehicle should take steps to establish that it is not effectively managed and controlled in China.
SEC enforcement actions
The SEC's Enforcement Division has continued to focus on companies with operations or activities, or both, in China but trading on US exchanges, while investigating allegations of accounting fraud has always been a focus of the SEC's Enforcement Division. The SEC's focus has expanded to investigating wide-ranging internal control, and books and records issues, including compliance with the Foreign Corrupt Practices Act (FCPA), at US-listed companies, as well as focusing on individual accountability. The SEC's expanded enforcement focus has extended to Chinese companies listed in the United States, and to private equity firms based in China or with investments in China.
In 2018, the number of SEC enforcement cases related to the FCPA was the third highest since 2008, with a total of 16 companies paying a record US$2.89 billion to US authorities in settlements. The increase in FCPA enforcement actions from 2017, when only seven settlements were recorded (an all-time low) suggests that FCPA enforcement remains a priority for the SEC. Among the 18 corporate FCPA cases brought by the SEC in 2018, one-third involved conduct related to the actions of Chinese subsidiaries of multinational companies or their activities in China. This included Credit Suisse, which agreed to pay more than US$47 million to settle allegations brought by both the SEC and the US Department of Justice (DOJ) that the bank provided valuable job and internship opportunities to relatives and friends of senior government officials and several Chinese state-owned entities as part of a quid pro quo arrangement for business.3 The Credit Suisse settlement is the third FCPA case against a major financial institution in two years related to the alleged improper hiring of relatives and friends of government officials and state-owned entity employees in China. In 2016, the SEC settled a similar case against JP Morgan Chase & Co for US$130 million.4
The SEC also focused on holding senior management accountable for individual liability in 2018. On 26 January 2018, Michael Cohen, a partner at Och-Ziff Capital Management Group and a member of the firm's management committee, and Vanja Baros, an analyst, were charged in an SEC civil complaint for violating the FCPA and aiding and abetting Och-Ziff's violations of the FCPA. These two individual cases brought by the SEC are on top of settlements that the Commission extracted from Och-Ziff and two other executives in 2016. The DOJ was also active in 2018, extracting six guilty pleas from individuals, including one from Julia Wang, a Chinese-born naturalised US citizen, who pleaded guilty to a plot to bribe the former president of the United Nations General Assembly.
Chinese authorities' enforcement actions
In addition to heightened scrutiny from US regulators, foreign private equity investors also face risks posed by Chinese authorities' anti-corruption and antitrust enforcement actions. These risks were showcased in continued enforcement actions against multinational companies.
Chinese anti-corruption enforcement update
In March 2018, China formed SAMR and folded the entire State Administration for Industry and Commerce (SAIC), the traditional enforcement authority for commercial bribery, into this new agency. It remains to be seen how the new SAMR will ramp up anti-corruption enforcement under the legal regime of the recently amended Anti-Unfair Competition Law (AUCL).
In 2018, the local Administrations for Market Regulation (AMRs) in Shanghai undertook aggressive anti-corruption enforcement actions by imposing 80 administrative penalties on individuals and entities in a variety of industries (e.g., healthcare, technology, manufacturing, construction and logistics), and around 20 per cent of those penalised were multinational companies. Selected high-profile enforcement cases are summarised below.
- In July 2018, the Shanghai Qingpu AMR imposed a fine of 150,000 yuan on Lepu Medical Technology (Shanghai) Co, Ltd (Lepu) for unduly influencing doctors at an industry conference by paying speaker fees totalling 32,800 yuan so that these physicians' presentation materials endorsed Lepu's products. The Shanghai Qingpu AMR noted in the penalty that the fine was relatively low because the company had no illegal income, and the speaker fee at issue was relativity small.
- In October 2018, the Shanghai Jiading AMR imposed a fine of 400,000 yuan on Shanghai Fenner Conveyor Belting Company (part of the Fenner Dunlop group) for providing gifts and cash-equivalent items in the amount of 70,350 yuan to five customers and then recording these expenses as manufacturing and operational costs in its internal system.
There is no evidence indicating that China's anti-corruption enforcement activities will slow down in 2019. In line with the amended AUCL, SAMR announced in May 2018 that China would put more emphasis on enforcements in the pharmaceutical and educational sectors, and any other sectors that may affect people's livelihood. Local rule-making and enforcement efforts were also stepped up. The Heilongjiang province enacted its local rules on regulating commercial bribery in the healthcare sector in late 2018 and the Zhejiang province investigated 36 cases in a variety of industries in the first half-year of 2018.
Chinese antitrust enforcement update
In addition to dissolving the SAIC, China consolidated the antitrust enforcement functions of two agencies – merger review under MOFCOM and antitrust investigations under the NDRC – into the newly established SAMR. It is expected that China's antitrust enforcement in the coming year will be more frequent, efficient and consistent.
Alhough experiencing a transitional period, China's antitrust enforcement activities continued to be aggressive. According to SAMR's official announcement, the new agency issued 15 penalty decisions in 2018 out of the 37 investigations initiated. The enforcement cases concerned companies across multiple sectors, including energy, pharmaceuticals, shipping and ports, public facilities and construction materials. High-profile enforcement cases are summarised below.
- In January 2018, the NDRC penalised two branches of PetroChina Company Limited for a total of 84.06 million yuan for reaching monopolistic agreements with 13 downstream compressed natural gas primary filling stations to restrict the resale minimum price.
- In November 2018, SAMR stated in a press conference that it had already 'made significant progress' in the investigation of Micron, Samsung and Hynix for allegedly exchanging information on a platform called DRAMeXchange to inflate DRAM prices. Subsequent media reports estimated that the penalties could reach US$8 billion.
- In December 2018, SAMR imposed a penalty totalling 6.25 million yuan on three glacial acetic acid active pharmaceutical ingredient (API) manufacturers, in addition to confiscating illegal gains for their price-fixing monopoly agreements. In December 2018, SAMR imposed a penalty totalling 12.43 million yuan on two chlorpheniramine maleate API manufacturers, as both companies abused their market dominance by refusing to deal with downstream entities without any justification. It has been reported that other investigations by local AMRs in relation to the API sector are also under way.
There is no evidence that Chinese antitrust enforcement will slow down in 2019 as the unified enforcement authority, SAMR, becomes increasingly more sophisticated and equipped to tackle larger and more complex cases. Furthermore, additional antitrust regulatory guidelines on IP, the automotive industry, exemptions and leniency have been approved by the Anti-Monopoly Committee of the State Council, and these new guidelines are expected to be issued and implemented in 2019.
In addition, China is working on improving the procedural posture of its antitrust enforcement process. In December 2018, SAMR promulgated the Interim Provisions Concerning the Procedures for Imposition of Administrative Penalties, which indicates that more detailed provisions on procedures may be drafted in the future.
iii Chinese outbound M&A
Chinese outbound investment approval and filing regimes
A proposed outbound investment in overseas target assets by a Chinese investor is subject to a series of outbound investment approval, filing and reporting requirements with competent Chinese authorities depending, inter alia, on the location and industry of the target assets, the investment amount, and the identity and ownership structure of the Chinese investor. An outbound investment made by Chinese individual investors through onshore or controlled offshore vehicles will be subject to relevant NDRC filing or reporting mechanisms.
The NDRC regulates Chinese companies' outbound investment activities on a project-by-project basis through a multilayered approval and filing regime. Under the Administrative Measures for Enterprise Outbound Investment (Regulation No. 11), which entered into force on 1 March 2018, a Chinese investor is required to make a filing with the NDRC or its local counterpart (depending on whether the Chinese investor is a centrally managed SOE and whether the investment size (including equity and debt investments made by not only the Chinese investor but also the offshore entities controlled by the Chinese investor) reaches US$300 million) and obtain an NDRC filing notice for an outbound investment transaction that does not involve a 'sensitive country or region' (countries and regions that are subject to investment restrictions under international treaties, war or civil commotion, or that have no diplomatic relations with China) or a 'sensitive industry' (to be further clarified by the State Council), and in cases where the transaction involves a sensitive country or region or a sensitive industry, the Chinese investor is required to apply for and obtain an outbound investment approval from the central NDRC. In addition, there has been a requirement that if the size of a Chinese outbound investment reaches or exceeds US$300 million, the Chinese investor is required to submit a project information report to the NDRC and obtain an NDRC project confirmation letter before signing a definitive purchase agreement, submitting a binding offer or bid, or submitting applications with foreign governmental authorities; however, this requirement of an NDRC project confirmation letter will be abolished from 1 March 2018 following the entry into effect of the new NDRC outbound rules. In addition to Regulation No. 11, the NDRC promulgated a Catalogue of Sensitive Industries for Outbound Investment 2018 (the Sensitive Industries Catalogue) in January 2018, with effect from 1 March 2018. In June 2018, the NDRC released the Answers to Frequently Asked Questions Concerning Outbound Investment by Enterprises (the Answers to FAQs) on its official website, providing clarification for 61 frequently asked questions regarding the application of Regulation No. 11. The NDRC made rather restrictive interpretations on the scope of sensitive projects. These industries or projects include real estate, hotels, offshore equity investment funds or investment platforms without specific underlying industrial projects, sports clubs, cinemas and the entertainment industry. The designation of real estate, hotels and offshore equity investment funds or investment platforms without specific underlying industrial projects as sensitive industries has drawn substantial attention, since there were significant amounts of investment both in numbers and deal values, in the few years before 2018. Regulation No. 11 adopts a control-based approach that includes in the verification scope all sensitive projects made by offshore entities under the control of Chinese investors, regardless of whether or not the Chinese investors provide financing or guarantees for these projects. Also of note is the fact that the restrictive interpretations of sensitive projects apply only to these three industries, namely real estate, hotels and offshore equity investment funds or investment platforms without specific underlying industrial projects, and do not include cinemas, entertainment, sports clubs or other sensitive industries. In addition to the aforementioned restrictive interpretations, the Answers to FAQs also include detailed explanations and instructions for each of the sensitive industries to clarify the scope of application of sensitive projects.
The NDRC and MOFCOM approvals and filings are typically the pre-closing procedures on the part of Chinese investors in outbound investment transactions, particularly if the Chinese investor needs to establish an offshore subsidiary or to use onshore financing (whether equity or debt financing), or both, to complete the transaction. If a Chinese buyer uses an existing offshore entity as the acquisition vehicle and has sufficient funds offshore to complete the transaction, the NDRC and MOFCOM approvals and filings, and even the registration with the State Administration of Foreign Exchange (SAFE) as described below, may not be required by the parties as closing conditions (although the Chinese buyer may nevertheless go through the process of obtaining and completing the NDRC and MOFCOM approvals and filings to be able to repatriate funds from the relevant investment back to China in the future). However, the aforementioned practice is restricted by the new NDRC outbound rules, which require that an investment of US$300 million or more made by an offshore entity controlled by a Chinese investor be 'reported' to the central NDRC, which will be a new post-closing government filing for an outbound transaction consummated by a Chinese investor's offshore subsidiary by utilising offshore financing.
After obtaining the NDRC and MOFCOM approvals and filings, a foreign exchange registration with SAFE through a local Chinese bank is required for the currency conversion and remittance of the purchase price out of China. However, this will not be applicable if a Chinese investor uses offshore capital to fund the transaction. In addition, a foreign exchange registration would be required in the case of an earnest deposit to be paid from China to overseas immediately upon or within a short period of the signing of a definitive purchase agreement. Upon registration, a Chinese investor may remit the registered amount of the deposit to offshore. However, if a Chinese investor uses its offshore funds to pay the deposit, this registration may not be applicable. The registration can be handled by a local Chinese bank concurrently with the NDRC project confirmation process if the amount of the deposit does not exceed US$3 million or 15 per cent of the purchase price. Payment of deposits of higher amounts must be approved by SAFE on a case-by-case basis after completing the NDRC project confirmation process.
A Chinese SOE as a buyer may also need approvals from the State-owned Assets Supervision and Administration Commission of the State Council or its local counterparts, or sometimes alternatively approvals from its group parent company. Depending on the transaction value and structure, a Chinese-listed company may need to obtain stockholders' approval before closing and make the necessary disclosures required by the Chinese securities exchange rules. The State Council requires the establishment of share capital systems for SOEs and improved auditing systems to monitor SOEs' outbound equity investments. This principle, accompanied by current rules applicable to SOEs' investments (e.g., appraisal), are regarded as intended to preserve and increase the value of state-owned overseas assets.
Since late 2016, it is reported that the increasing flow of Chinese outbound investment activities has become a source of concern to Chinese authorities, which have adopted more stringent control and supervision on outbound investment activities and capital flow. In an official press release dated 6 December 2016, the central governmental authorities, including the NDRC, MOFCOM and SAFE, in their response to a media inquiry on tightened scrutiny over outbound investment transactions, mentioned that they had been alerted to some irrational outbound investment activities in real estate, hotels, film studios, the entertainment industry and sports clubs, and potential risks associated with overseas investment projects involving:
- large investments in businesses that are not related to the core businesses of the Chinese investors;
- outbound investments made by limited partnerships;
- investments in offshore targets that have assets of a value greater than the Chinese acquirers;
- projects that have very short investment periods; and
- Chinese onshore funds participating in the going-private of offshore-listed China-based companies.
Further, on 4 August, 2017, the State Council issued the Guidance Opinions on Further Promoting and Regulating Overseas Investment Direction (the Guidance Opinions), which highlighted certain industry-specific guidance affecting Chinese outbound investments, including:
- encouraging investments in overseas high-tech and manufacturing companies and in setting up overseas research and development (R&D) centres;
- promoting investments in agricultural sectors;
- regulating investments in oil, mining and energy sectors based on an evaluation of the economic benefits;
- restricting investments in real estate, hotels, cinemas, the entertainment industry and soccer clubs; and
- prohibiting investments in the gambling and pornography sectors.
In addition, the Guidance Opinions classify investments in offshore private equity funds or investment vehicles that do not have investment projects as restricted investments, which would be subject to pre-completion approvals by the NDRC.
The tightened control on outbound investment activities and capital flow not only affect Chinese investors, but are also relevant to international private equity participants from at least two perspectives: when a private equity participant intends to partner with a Chinese investor in M&A outside China, or when a private equity participant is considering a Chinese buyer for a trade sale as its exit route. As mentioned previously, the NDRC promulgated the Sensitive Industries Catalogue in 2018, formally adopting the aforementioned measures. In these scenarios, the private equity investor must take into account the potential risk that the Chinese party may not be able to come up with sufficient funds offshore in time to complete the transaction offshore or ultimately complete the transaction. Further, when private equity investors consider a Chinese buyer as a potential exit route, in addition to the completion risk, a private equity seller would be well-advised to also consider the risk profile of the transaction and the target business in the context of Chinese regulations (including the relevant industry, the financing structure and the identity of the Chinese buyer) to evaluate the related risks and impacts, including reputational risks and social impacts, if the Chinese buyer was required to divest the business shortly after completing the transaction or was unable to supply the required funding offshore for the business, which may put stress on various aspects of the operation of the business and may also force a premature sale.
Non-Chinese investment approvals
The United States, the EU and other countries scrutinise or regulate international business activities, including relevant Chinese outbound investment activities, to achieve objectives related to, inter alia, national security, foreign investment control and anti-monopoly. In connection with Chinese investments in the United States or EU countries, the relevant parties should be aware of potential non-Chinese approvals that may be mandatory or necessary in the jurisdiction where the target is located depending on the nature and size of the transaction, which may include US and EU merger control review, and a Committee on Foreign Investment in the United States (CFIUS) review. A CFIUS review is often perceived among parties to Chinese outbound investments in the United States as one of the major foreign regulatory hurdles. The scrutiny of acquisitions by Chinese companies has been further intensified in the United States (following the reform of CFIUS legislation in late 2018) and in some other western countries.
CFIUS is an inter-agency committee of the US government that is empowered to monitor foreign direct investment in the United States by a non-US person, to evaluate whether the transaction may create national security risks. CFIUS establishes the process for reviewing the national security impact of foreign investments, joint ventures and other investments into the United States, and analyses a broad range of national security factors to evaluate whether a transaction may create a national security risk to the United States.
On 13 August 2018, US President Trump signed into law the Foreign Investment Risk Review Modernization Act (FIRRMA), which substantially reformed and expanded the jurisdiction and powers of CFIUS, including (1) expanding the jurisdiction of CFIUS, which expressly included not only controlling direct investments, but also certain non-controlling investments for the first time; (2) adopting a mandatory declaration process for certain covered transactions together with mandatory waiting periods for the closing of those transactions; (3) extending the statute timeline in respect of the review process; and (4) granting enforcement authority for CFIUS to suspend transactions. On 11 October 2018, CFIUS further promulgated a pilot programme, which took effect on 11 November 2018, strengthening and detailing regulations affecting 27 identified industry sectors (e.g., R&D in biotechnology, petrochemical manufacturing, and semiconductor and related device manufacturing). Given that the relationship between the United States and China has deteriorated since the Trump administration took the office, FIRRMA, together with the pilot programmes implemented by CFIUS, is likely to have a dramatic and disproportionate impact on Chinese outbound investments into the United States, especially investments in the highly sensitive areas affected (including sensitive personal data, critical infrastructure, critical technology and, particularly, any state-directed investments) in the near future.
Recent major Chinese outbound investment transactions abandoned or terminated on account of CFIUS issues include:
- the termination in February 2018 of the US$580 million acquisition of US semiconductor testing company Xcerra Corp by Hubei Xinyan Equity Investment Partnership due to the parties' failure to obtain CFIUS approval;
- the termination in January 2018 of an attempted US$1.2 billion strategic acquisition of US money transfer company MoneyGram International Inc by Chinese financial service provider and affiliate of Alibaba, Ant Financial Services Group, due to the CFIUS refusal of approval over national security concerns;
- the termination in November 2017 of US$100 million investment in US financial services firm Cowen Inc by CEFC China Energy Company Limited;
- the executive order issued by President Trump in September 2017 blocking a proposed US$1.3 billion sale of Lattice Semiconductor Corporation, a publicly traded US manufacturer of programmable logic chips, to a Chinese state-backed private equity firm;
- the abandonment in September 2017 of the US$285 million proposed 10 per cent equity investment in HERE Technologies by a part-Chinese consortium;
- the termination in July 2017 of the US$103 million acquisition of American in-flight entertainment company Global Eagle by the Chinese conglomerate HNA due to parties' inability to obtain CFIUS approval;
- the executive order issued by President Obama in December 2016 blocking the proposed acquisition of German semiconductor manufacturer Aixtron SE's US business by a group of Chinese investors led by Fujian Grand Chip Investment Fund LP;
- the termination in January 2016 of the attempted acquisition of Philips NV's Lumileds LED business by a consortium of Chinese investors led by GO Scale Capital due to parties' failure to address national security concerns raised by CFIUS;
- termination in February 2016 of the proposed investment in Western Digital by Unis Union and Unisplendour after CFIUS determined to investigate the transaction; and
- rejection by US chipmaker Fairchild Semiconductor International in February 2016 of a bid from China Resources Microelectronics citing an 'unacceptable level' of CFIUS risk.
In addition to the United States, other western countries have tightened control over investment by Chinese companies in certain sensitive industries, which has resulted in the termination of certain acquisition attempts by Chinese companies. Germany enacted an amendment to the German Foreign Trade and Payments Ordinance (AWV) in July 2017, pursuant to which any acquisition of at least 25 per cent voting rights of German companies by a non-European Economic Area investor is subject to a foreign investment control approval by the German government. On 20 December 2018, Germany promulgated a new amendment to the AWV, lowering this threshold from 25 per cent to 10 per cent for certain investments in the industries of 'critical infrastructure' or 'military-related products'. Notable examples of failed attempts by Chinese companies in Germany include an attempted takeover of the Westphalian mechanical engineering company Leifeld Metal Spinning on 1 August 2018 by Yantai Taihai, a leading participant in the Chinese nuclear sector.
III YEAR IN REVIEW
i Recent deal activity
The trend of US-listed Chinese companies going private heated up to record levels in 2015 and 2016, retreated from these peak levels in 2017 and cooled down further in 2018. Based on statistics obtained through searches on Thomson ONE:
- during 2014, eight US-listed going-private transactions were announced and 18 were closed;
- during 2015, 27 US-listed going-private transactions were announced and six were closed;
- during 2016, 16 US-listed going-private transactions were announced and 15 were closed; and
- during 2017, six US-listed going-private transactions were announced and five were closed; and
- during 2018, 10 US-listed going-private transactions were announced and only one was closed
The struggle by some Chinese companies against market research firms and short sellers such as Muddy Waters Research, Citron Research and Blue Orca Capital has often provided interesting perspectives on the environment faced by Chinese companies listed in the United States. These market research firms and short sellers have gained name recognition by issuing critical research reports targeting Chinese companies listed in the United States. The business model of such firms appears to involve issuing negative research reports on a public company while simultaneously taking a short position in the company's stock, which often enables these firms to make substantial profits even if their research and accusations are not ultimately proven correct. Notably, these firms have not limited their coverage to companies listed through reverse takeovers (RTOs),5 which are commonly considered to have lower profiles and to be more prone to disclosure issues than companies listed through a traditional IPO process.
Following the consequential coverage by Muddy Waters of Orient Paper Inc in 2010 and Sino-Forest Corp in 2011, the most notable case in 2012 arose when, on 18 July 2012, Muddy Waters published a scathing report on New Oriental Education & Technology Group Inc on its website, sinking the company's share price to US$9.50 by 35 per cent in one day. New Oriental is widely considered one of the more reputable and well-run Chinese companies listed in the United States, and it went public in a traditional IPO. The company's stock price subsequently recovered to US$13.90 one and a half months after the Muddy Waters report came out, suggesting the market's belief that the accusations were not justified. New Oriental's stock, at the time of writing, trades at US$65.90. On 14 November 2018, Blue Orca Capital issued a short-selling report, accusing Pinduoduo Inc, a social commerce company in China, of inflating revenues and falsely trimming losses. Blue Orca Capital predicted a 59 per cent drop in the company's stock price in its negative report, whereas Pinduoduo's stock price experienced a surge after the announcement of its quarterly result following Blue Orca Capital's report, suggesting that investors in the US market as a whole can act quite independently of such negative research reports and short-selling attempts. On the other hand, on 24 October 2013, Muddy Waters published an 81-page report labelling Beijing-based mobile provider NQ Mobile Inc a 'massive fraud', sending the company's share price tumbling more than 60 per cent in three days. NQ Mobile's share price experienced substantial recovery during Q4 2013 and Q1 2014 but lost more than 80 per cent in value amid continued attacks from Muddy Waters and traded below US$4 for most of 2017, or less than one-fifth of its 2013 high. NQ Mobile Inc was eventually delisted from the New York Stock Exchange (NYSE) on 9 January 2019.
Regardless of the ultimate outcome, the fact that a single research report could inflict sudden and substantial damage of this nature on a company's reputation and stock price strongly suggests a widespread underlying lack of confidence in listed Chinese companies. The success of these research and short-selling firms could also be partially attributed to a lack of access to and understanding of the Chinese business environment and markets, which have afforded a few firms that have conducted on-the-ground research outsize influence in the market. Further, their critical coverage, which often involves allegations of disclosure issues or even fraud, has attracted regulatory attention and shareholder lawsuits and may have encouraged less-than-generous media coverage of Chinese companies in general. For instance, in 2013, the SEC publicised its investigations and charges against US-listed China MediaExpress and its chair and CEO for fraudulently misrepresenting the company's financial condition to investors in SEC filings dating back to November 2009, and against RINO International Corporation, a China-based manufacturer and servicer of equipment for China's steel industry, and its chair and CEO for a series of disclosure violations based on accounting improprieties, after (or shortly before) Muddy Waters initiated coverage and issued negative reports regarding these companies. The above factors, in turn, are believed to have contributed to suppressed valuations of US-listed Chinese companies in general.
Amid continued pressure from regulators, unfavourable media coverage, short-selling activities and shareholder lawsuits, the stock prices of many US-listed Chinese companies are perceived to be consistently depressed. Further, even Chinese companies relatively free of negative coverage have often felt that their business model and potential are not fully appreciated by the US market, and that they would be more favourably received by a market closer to China – for example, the Hong Kong Stock Exchange or the Chinese A-share market – where market research and media coverage are seen as being more positive and reflecting a proper appreciation of the business culture and environment in China, resulting in a better understanding of the specific business models and potential of the companies covered. At the same time, the booming domestic Chinese stock market (with an average price-to-earnings (P/E) ratio of 12.49 at the end of 2018, 18.08 at the end of 2017, 15.91 at the end of 2016 and 17.61 at the end of 2015 for A-share listed companies listed on the Shanghai Stock Exchange, and an average P/E ratio of 20 at the end of 2018, 36.21 at the end of 2017, 41.62 at the end of 2016 and 53.34 at the end of 2015 for A-share listed companies listed on the Shenzhen Stock Exchange) often offered valuations several times over those offered in the United States.
The disparity in valuation levels and perceived receptiveness naturally presented a commercial case for management and other investors to privatise US-listed Chinese companies, with the hope of relisting them in other markets. One of the most significant going-private transactions to date was the proposed acquisition of Qihoo 360 Technology Co Ltd by a consortium consisting of its co-founder and chair, Mr Hongyi Zhou, its co-founder and president, Mr Xiangdong Qi, and certain other investors, in a transaction valuing the NYSE-listed company at approximately US$9.3 billion (not taking into account rollover shares to be cancelled for no consideration). This deal was closed in July 2016 and was the largest privatisation of a US-listed Chinese company (the second-largest being the take-private of Qunar Cayman Islands Ltd by Ocean Imagination LP, which was signed in 2016, valuing Qunar at US$4.59 billion).
While earlier going-private transactions involving US-listed Chinese companies tended to run more smoothly, some more recent transactions of this type went through more eventful processes, suggesting the challenges in completing such transactions have been increased by a more competitive dealmaking environment with a shrinking pool of desirable targets and a more seasoned shareholder base. For example, in the going-private transaction of NASDAQ-listed Yongye International Limited, the initial bid of the buyer consortium led by Morgan Stanley Private Equity Asia and the company's CEO failed to receive the requisite shareholders' approval, and the transaction was approved in a subsequent shareholder meeting only after the buyer consortium raised its bid by 6 per cent. In the going-private transaction of hospital operator Chindex International Inc, the initial offer of US$19.50 per share from the buyer consortium comprising Shanghai Fosun Pharmaceutical, TPG and the company's CEO was countered by a rival offer of US$23 per share received by the company in the 'go-shop' period, and the buyer consortium eventually had to raise its offer to US$24 a share to secure the transaction, raising the total price tag to US$461 million. A more recent case that has been drawing market attention is iKang Healthcare. While the iKang special committee was considering a going-private proposal submitted in August 2015 by a consortium led by Ligang Zhang, its founder, chair and CEO, and FountainVest, in November 2015 the iKang board received a competing proposal from a consortium led by one of iKang's main competitors, Meinian Onehealth Healthcare (Group) Co, Ltd, a Shenzhen-listed company. The founder-led consortium and the Meinian-led consortium then engaged in an intense publicity war, iKang's board adopted a poison pill and Meinian increased its offer price for the second time. In June 2016, after the board of directors of iKang received a competing go-private proposal from Yunfeng Capital (a private equity firm co-founded by Alibaba Group Holdings Ltd's Jack Ma and Focus Media Holdings' David Yu) to acquire the entire share capital in iKang, both the founder-led consortium and the Meinian-led consortium withdrew their going-private proposals. After 21 months' negotiation, a reorganised consortium led by Yunfeng Capital, Alibaba Group Holdings and BOYU Capital, Ligang Zhang and Boquan He, the vice president of iKang, managed to enter into a merger agreement on 26 March 2018, pursuant to which the reorganised consortium proposed an offer at US$41.20 per share (or US$20.60 per American depositary share of the company (ADS)), with a total value of approximately US$1.097 billion. This offer was approved by iKang's general shareholders' meeting on 20 August 2018, and the merger was closed and officially announced on 18 January 2019.
The going-private trend was not limited to entities resulting from an RTO. While companies listed through RTOs may be easier targets of short sellers, companies that listed in the United States through a conventional offering may be more appealing targets for private equity investors given that these companies are often perceived to be of higher quality and less likely to have accounting or securities law compliance issues, and thus are more likely to grab a higher valuation later on, whether in an IPO in a market closer to China or a trade sale. Indeed, all of the examples discussed above involved companies listed through a traditional IPO.
A majority of US-listed China-based companies involved in going-private transactions in recent years are incorporated in the Cayman Islands. Four out of the six US-listed China-based companies that announced receipt of a going-private proposal in 2017 were Cayman Islands companies (and one is a British Virgin Islands company) that accessed the public markets through a conventional IPO, compared with 13 Cayman Islands or British Virgin Islands companies out of 15 US-listed China-based companies in deals announced in 2016, 23 Cayman Islands companies out of 24 US-listed China-based companies in deals announced in 2015, and four Cayman Islands or British Virgin Islands companies out of five significant China-based companies in deals announced in 2014. This was driven in part by the introduction of new merger legislation in the Cayman Islands in April 2011, which made statutory merger under the Cayman Islands Companies Law an attractive route to effect a going-private transaction. The merger process typically requires the buyer group to form a new Cayman Islands company that will merge with, and be subsumed by, the listed Cayman target. Under the 2011 amendments to the Cayman Islands Companies Law, the shareholder approval threshold for a statutory merger was reduced from 75 per cent to a two-thirds majority of the votes cast on the resolution by the shareholders present and entitled to vote at a quorate meeting, in the absence of any higher threshold in the articles of association of the target company. In additional, a merger under the Cayman Islands Companies Law is not subject to the 'headcount' test required in a scheme of arrangement, the primary route for business combination under the Cayman Islands Companies Law before merger legislation was introduced in the Cayman Islands. The headcount test requires the affirmative vote of 'a majority in number' of members voting on the scheme, regardless of the amount or voting power of the shares held by the majority, which means that a group of shareholders holding a small fraction of the target's shares could block a transaction. The lower approval threshold makes mergers an attractive option when compared with either a 'squeeze-out' following a takeover offer, which would require the buyer to obtain support from 90 per cent of the shares, or a scheme of arrangement, which would involve substantial closing uncertainty on account of the headcount test, as well as added time and costs arising from the court-driven process.
Most of the going-private transactions that closed in 2018 and 2017 took between two and five months from the signing of definitive agreements to close (the rest took five months or longer) and were structured as a one-step, negotiated merger (as opposed to a two-step transaction consisting of a first-step tender offer followed by a second-step squeeze-out merger, which is another common approach to acquire a US public company). In a one-step merger, a company incorporated in a US state will be subject to the US proxy rules, which require the company to file a proxy statement with the SEC and, once the proxy statement is cleared by the SEC, to mail the definitive proxy statement to the shareholders and set a date for its shareholders' meeting. Transactions involving affiliates (e.g., management) are further subject to Rule 13e-3 of the Securities and Exchange Act, and are commonly referred to as '13e-3 transactions'. A 13e-3 transaction requires the parties to the transaction to make additional disclosures to the public shareholders, including as to the buyer's position on the fairness of the transaction. An important related impact is that, whereas the SEC reviews only a fraction of all proxy statements, it routinely reviews disclosure in 13e-3 transactions, which can lengthen the transaction process by several months. Further, companies incorporated outside the United States and listed on US stock exchanges (including recent going-private targets that often are incorporated in the Cayman Islands or the British Virgin Islands) are known as foreign private issuers (FPIs). While FPIs are not subject to the proxy rules, they are subject to 13e-3 disclosure obligations, and if they are engaged in a 13e-3 transaction, they would be required to include as an exhibit to their 13e-3 filings information that is typically very similar to a proxy statement prepared by a US domestic issuer. Accordingly, both a transaction involving a US domestic company and a 13e-3 transaction involving an FPI follows a comparable timetable for purposes of SEC review.
It is worth noting that the recent tightening of control on capital flows out of China, including regulations restricting Chinese onshore funds from participating in the going-private of offshore-listed China-based companies may also create hurdles for going-private transactions of offshore-listed China based companies as these transactions typically involve buyer parties or financing, or both, from China. It remains to be seen how long the tightened control on outbound capital flow will last and its exact impact on going-private transactions involving Chinese companies.
Another key recent trend in going-private transactions of US-listed Chinese companies that are incorporated in Cayman is the rise of dissenting shareholders in such deals. Many of the US-listed and Cayman-incorporated Chinese companies that have recently gone private are facing dissenting shareholder litigations under Section 238 of the Companies Law of the Cayman Islands by investors who claim that their shares are worth more than the offer price. Often, the buyer groups are accused of forcing through low-ball offers by virtue of their significant voting rights. Low-ball offers are possible partially because Cayman Islands law allows buyer groups to vote their shares, including super voting shares, together with the other shareholders, towards the two-thirds in voting power represented by shares present and voting at the shareholders' meeting required for approval of the merger. For example, the buyer groups in the take-private of Mindray and Shanda Games held 63.1 and 90.7 per cent, respectively, in voting rights in the relevant target companies. Some private equity shareholders in going-private transactions have publicly complained or made Schedule 13D filings with the SEC about low-ball offers from Chinese buyout groups.
In January 2017, the Cayman Islands Grand Court delivered its interlocutory judgment regarding the Blackwell Partners LLC v. Qihoo case, in which it decided that interim payments could be requested by dissenting shareholders and granted by the court during the judicial proceedings for the merger transactions initiated under Section 238 of the Companies Law of the Cayman Islands. In April 2017, the Cayman Islands Grand Court delivered its ruling in the Shanda Games case, in which it found that the fair value of the shares owned by the dissenting shareholders (which were all funds managed by Hong Kong-based fund manager Maso Capital) was more than double the consideration offered in the take-private scheme. These decisions, in hindsight, are perceived to be instrumental in shaping the dissenting shareholder landscape in the Cayman Islands. The Shanda Games case was the second Cayman court decision on fair value in a merger, and the first one that required the Cayman court to determine the value of a company with assets and business operations in China. While the Shanda Games decision further propped up expectations of dissenting shareholders of a court-determined fair value that is substantially higher than the price offered by the buyer group, the Qihoo decision (together with a few other similar decisions) perhaps dealt the more decisive blow by enabling the dissenting shareholders to recover interim payments (which are often equal to the price offering in the take-private) relatively soon after initiation of litigation, significantly reducing the cost of funds for dissenting shareholders.
Currently, several similar additional cases are pending in the Cayman Islands courts, and it remains to be seen whether future Cayman court decisions will balance market expectations and discourage speculative dissenters. One of the cases demonstrating these balancing efforts is the decision of the Cayman Islands Grand Court in the going-private transaction of eHi Car Services Ltd (eHi), the provider of passenger car rental services in China. In June 2018, the Cayman Islands Grand Court decided that the dissenting minority shareholder of eHi could not pursue a winding-up petition intended to delay, or to gain leverage for, a competing merger bid for the privatisation of eHi. To compete against a proposal at US$13.35 per ADS offered by a consortium led by Baring Private Equity Asia Limited and Ruiping Zhang, the chairman of eHi group, Ctrip Investment Holding Ltd, a dissenting minority shareholder of eHi, submitted a counter proposal at US$14.50 per ADS. This proposal, although at a higher offer price, was not recommended by the special committee to the board of directors of eHi because it was considered to be a last-minute increase from the price offered in the proposal submitted by Baring and the chairman. Ctrip Investment Holding Ltd then presented a winding-up petition together with an immediate injunction to the Cayman Islands Grand Court. The Court struck out the winding-up petition in its entirety on the ground of abusive use of the winding-up jurisdiction by the dissenting shareholder. Although a reorganised consortium led by Ctrip Investment Holding Ltd and Ocean Imagination LP eventually won the competing bid with a revised proposal at US$15.50 per ADS in May 2018, the Cayman Islands Grand Court's decision in this case now stands as an exemplary case for the principle that a winding-up petition may not be abusively used by dissenting shareholders to avoid a going-private transaction.
Other notable transactions
Consolidations in the vying internet and technology industries in China have been soaring and hitting headlines for several consecutive years. In February 2015, Didi Dache and Kuaidi Dache, two of China's leading ride-hailing apps, announced their US$6 billion stock-for-stock merger, which was closed weeks thereafter, creating Didi Kuaidi (later rebranded as Didi Chuxing), one of the world's largest smartphone-based transport service providers. In August 2016, Didi Chuxing announced its acquisition of Uber China (Uber's China business), which was valued at around US$8 billion, and after the transaction, Didi Chuxing was estimated to be worth around US$35 billion. Uber obtained a 17.7 per cent stake in Didi Chuxing and became the largest shareholder of Didi Chuxing, with other existing investors in Uber China, including Chinese search giant Baidu Inc, taking another 2.3 per cent stake in Didi Chuxing. In April 2015, NYSE-listed 58.com purchased a 43.2 per cent fully diluted equity stake in Ganji.com for US$1.56 billion, initiating the long-term strategic combination of these two major online classified providers in China. In October 2015, two major online-to-offline (O2O) service providers in China, the group-buying service Meituan.com and restaurant review platform Dianping Holdings, announced a merger to create a US$15 billion giant player in China's O2O market covering restaurant review, film booking and group buying businesses. In late October 2015, China's largest online tourism platform, Ctrip, announced the completion of a share exchange with Baidu, Inc through which it gained control of its rival Qunar. The transaction formed a dominant player in the online trip booking market in China valued at US$15.6 billion. In January 2016, Meilishuo.com, a Chinese fashion retailer backed by Tencent Holdings Ltd announced its merger with its chief rival, Mogujie.com, to form the biggest fashion-focused e-commerce service provider in China with a valuation of nearly US$3 billion. In September 2017, the merger of two major online film-ticketing platforms was announced between Maoyan (majority-owned by Chinese television and film company Enlight Media) and Weying (backed by Tencent). Following the merger, the combined Maoyan-Weying entity will control 43 per cent of China's online ticketing market, according to Enlight Media's announcement. In April 2018, Ele.me, a leading online food order and local delivery services platform in China, announced the completion of its merger into Alibaba Group Holdings Limited, with a valuation of US$9.5 billion. Following the merger, Ele.me has become a part of the Alibaba ecosystem by complementing Alibaba's current local services platform, Koubei, and providing extended synergies to Alibaba's new retail business sector in the long run.
In addition to the iconic mergers described above, the headline private equity investments in 2018 primarily focused on China's technology industries. In April 2018, Pinduoduo Inc, the leading 'new-ecommerce' platform, which features a team purchase model, announced the completion of its pre-IPO financing at a valuation of US$15 billion with Sequoia Capital and Tencent Holdings. In June 2018, Ant Financial Services Group, the leading online payment service provider and the financial arm of the Alibaba Group, announced the completion of its US$14 billion Series C financing (with a valuation of US$150 billion) from a series of private equity and sovereign funds, including Baillie Gifford & Co, BlackRock Private Equity Partners, Canada Pension Plan Investment Board, The Carlyle Group, General Atlantic LLC, GIC Special Investments, Janchor Partners, Khazanah Nasional Bhd, Sequoia Capital, Silver Lake Partners, T Rowe Price, Temasek Holdings and Warburg Pincus. In October 2018, ByteDance/Toutiao, the leading internet content platform in China, announced the completion of its pre-IPO financing at a valuation of US$75 billion from leading global private equity funds, including General Atlantic, KKR, Primavera and SoftBank.
Another noteworthy trend in recent years has been private equity investors' participation in the mixed ownership reform of China's SOEs, where Chinese SOEs introduce private investors as minority shareholders. The highlight of this trend was the US$2.4 billion acquisition in 2014 of a 21 per cent equity interest in China Huarong Asset Management Co, Ltd, one of the largest asset management companies in China that was listed on the Hong Kong Stock Exchange in 2015 by a consortium of investors including China Life Insurance (Group) Company, Warburg Pincus, CITIC Securities International Company Limited, Khazanah Nasional Berhad, China International Capital Corporation Limited, China National Cereals, Oils and Foodstuffs Corporation (COFCO), Fosun International Ltd and Goldman Sachs. Warburg Pincus was reported to have bought the largest portion of a 21 per cent stake for close to US$700 million. In August 2017, Wealth Capital, a Beijing-based private equity firm, set up a 5 billion yuan investment fund in Beijing targeting SOEs undergoing mixed ownership reform, in which the state-backed China Structural Reform Fund (a 350 billion yuan SOE restructuring fund backed by investors including China Chengtong Holdings Group, China Merchants Group and China Mobile) has invested and Wealth Capital acts as the fund manager, which is just one of many similar SOE reform-targeted funds that are being set up by state-owned capital and private equity funds across China.
Third-party debt financing continues to be available for acquisitions of Chinese companies by private equity investors. One key challenge, however, is that a Chinese target does not generally have the ability to give credit support (by way of guarantee or security over its assets) to a lender of offshore acquisition debt financing. Further, with a view to deleveraging and strengthening the economy, the Chinese authorities imposed various new foreign debt controls in 2018, which will impact the availability of security and financing to be provided by Chinese entities and financial institutions. For instance, insurance companies have been restricted from providing outbound guarantees for offshore debt; domestic Chinese companies raising foreign debt have been subject to higher governance standards; local government entities have been prohibited from providing outbound guarantees for offshore borrowing and real estate companies have been restricted from using foreign debt in relation to real estate projects.
Many of the going-private transactions of US-listed Chinese companies involved debt financing, with the terms of the financings reflecting various commercial and structural challenges. The acquisition debt is typically borrowed by an offshore acquisition vehicle with the borrower giving security over its assets (including shares in its offshore subsidiaries, including the target) to secure repayment of the debt. As was the case in 2011 and 2012, the typical lender in these transactions spanned a wide range of financial institutions, from international investment banks to Chinese policy banks and offshore arms of other Chinese banks.
The Focus Media financing remains the standout transaction among debt-financed going-private transactions, due mainly to the size (US$1.52 billion) and complexity of the debt-financing facility, and the large consortium of both major international banks (Bank of America Merrill Lynch, Citibank, Credit Suisse, DBS Bank, Deutsche Bank and UBS) and offshore arms of Chinese banks (China Development Bank, China Minsheng and ICBC) that provided the financing. The 7 Days Inn financing was another notable debt-financed going-private transaction that was largely financed by a syndicate of Asian banks (Cathay United Bank, China Development Industrial Bank, CTBC Bank, Entie Commercial Bank, Nomura, Ta Chong, Taipei Fubon Commercial Bank, Bank of East Asia and Yuanta Commercial Bank). The debt financing for the Giant Interactive take-private was also underwritten and arranged by a large syndicate of banks, including China Minsheng Banking Corp, BNP Paribas, Credit Suisse, Deutsche Bank, Goldman Sachs, ICBC International and JP Morgan, in an aggregate amount of US$850 million. It can perhaps be considered a positive signal for any future going-private transactions that such a large number of financiers were comfortable to commit to funding this type of event-driven financing.
One notable development since 2015 is reflected in the going-private of Qihoo. Rather than obtaining the debt financing in US dollars offshore, the entire financing of a yuan equivalent of approximately US$3.4 billion was provided by one Chinese bank (China Merchants Bank (CMB)) onshore in yuan, with the buyer group having obtained the required Chinese regulatory approvals to convert the yuan funded by CMB into US dollars for payment of consideration to Qihoo's shareholders offshore. It remains to be seen whether this relatively novel deal structure will gain popularity, as both Chinese regulatory authorities and financial institutions gain more familiarity with this type of take-private transaction involving US-listed and China-based companies. The tightened control over outbound capital flow since late 2016 discussed above may deter the wide usage of this type of financing structure.
Another emerging trend in these offshore financing structures is that borrowers are seeking to access liquidity from the offshore debt markets in respect of what are essentially acquisitions of Chinese-based businesses – including as a means to take out bridge financing originating outside Asia.
iii Key terms of recent control transactions
Deal terms in going-private transactions
Most Chinese going-private transactions have involved all-cash consideration. Among the US-listed going-private transactions that closed during 2017, the per-share acquisition price represented an average premium of 17.5 per cent over the trading price on the day before announcement of receipt of the going-private proposal, according to statistics obtained through searches on Thomson ONE.
In a 13e-3 transaction (the going-private of a US-listed company involving company affiliates), the board of directors of the target typically appoints a special committee of independent directors to evaluate and negotiate the transaction and make a recommendation to the board. If the target is incorporated in the United States, the transaction almost inevitably will be subject to shareholders' lawsuits, including for claims of breaches of fiduciary duties, naming the target's directors as defendants. Because the target's independent directors often include US residents, a key driver of a transaction's terms is the concern for mitigating shareholders' litigation risk. Although no litigation claims for breach of fiduciary duties in a Chinese going-private transaction involving Cayman Islands or British Virgin Islands companies were reported to the public in 2017, it remains possible that, as the going-private trend persists, plaintiffs' firms will begin to articulate creative arguments in Cayman mergers and the Cayman courts may look to the body of Delaware law as persuasive precedent for adjudicating claims of breach of fiduciary duties. As a result, whether a going-private transaction involves a US or Cayman-incorporated target, targets typically insist that certain key merger agreement terms (in addition to the deal process) be within the realm of what constitutes the 'market' for similar transactions in the United States.
An important negotiated term in many going-private transactions is the required threshold for shareholder approval. Delaware law requires that a merger be approved by shareholders owning a majority of the shares outstanding. However, special committees often insist on a higher approval threshold, because under Delaware law the burden of proving that a going-private transaction is 'entirely fair' to the unaffiliated shareholders often shifts from the target directors to the complaining shareholders if the transaction is approved by a majority of the shareholders unaffiliated with the buyer group (i.e., a 'majority of the minority'). In US shareholder litigations, this burden shift is often seen as outcome-determinative. Under Cayman law, there is no well-defined benefit for the company to insist on a higher approval threshold than the statutory requirement of two-thirds of the voting power of the target present at the shareholders' meeting.
Another key negotiation point is whether the target would benefit from a go-shop period, which is a period following the signing of a transaction agreement during which the target can actively solicit competing bids from third parties. When defending against a claim of breach of fiduciary duty in Delaware, a company and its directors may point to a go-shop period in a merger agreement as a potentially helpful fact. Under Cayman law, however, there is not as much well-defined benefit for the company to insist on a go-shop period if the buyer consortium already has sufficient voting power to veto any other competing merger proposal.
Deal terms in growth equity investments
Deal terms are more difficult to evaluate and synthesise in private transactions, where terms are not publicly disclosed. Generally, in the context of a growth equity investment (which, as we have seen, remains the dominant type of deal both by number of deals and by aggregate amount invested), private equity investors often continue to expect aggressively pro-buyer terms. This expectation applies whether a transaction involves an onshore Sino-foreign joint venture or an investment offshore alongside a Chinese partner. In a subscription agreement for a growth equity deal, an investor typically benefits from extensive representations and warranties against which the company makes only limited disclosures; in some cases, an investor has knowledge that some representations may not be accurate, but still insists on a representation to facilitate a potential indemnification claim later. It is not uncommon for an investor to also enjoy an indemnity provision with a cap on the amount of losses subject to indemnification as high as the purchase price (or no cap at all), but with no deductible or threshold and with an unlimited survival period. Shareholders' agreements often contain similarly pro-investor terms, such as extensive veto rights (even in the case of a relatively small minority stake) and various types of affirmative covenants binding the company and its Chinese shareholders. If an investment is structured offshore (e.g., through a Cayman company that owns a Chinese subsidiary), a private equity investor may enjoy 'double-dip' economics pursuant to which, in the event of a liquidation or sale of the company, the investor is entitled to, first, a liquidation preference before any of the Chinese shareholders receive any proceeds and, second, the investor's pro rata share of the remaining proceeds based on the number of shares it owns on an as-converted basis. However, because there is no well-defined market when it comes to transaction terms in Chinese growth equity deals (unlike in going-private transactions), issuers also have opportunities to request, and sometimes obtain, terms that are very favourable to them. In growth equity deals in China, investors typically seek valuation adjustments or performance ratchet mechanisms, which can be structured as the adjustment to conversion prices of preferred shares that may be exchanged into a larger number of common shares at offshore level, or by compensation or redemption of equity interest in cash or transfer of equity interest to investors by the founders or original shareholders at onshore level without consideration or with nominal consideration, so as to achieve adjusted valuation of the target company following the failure to meet specified performance targets. In Chinese growth equity investments, the parties' leverage and degree of sophistication are more likely to dictate the terms that will apply to a transaction than any market practice or standard. In recent years, growth equity investments into high-growth technology companies have begun to contain less investor-friendly deal terms (e.g., new investors receiving pari passu liquidation preference with previous investors) as competition among private equity firms to make investments into this sector continues to heat up.
For a private equity investor with sufficient commercial leverage, the key challenge often lies not in convincing the investee company or its Chinese shareholders to agree to adequate contractual terms, but rather in getting comfort that an enforceable remedy will be available in the event that the Chinese counterparty reneges on its contractual obligations. One potential antidote to the difficult enforcement environment onshore is to seek a means of enforcement offshore. An investor can get comfort if it obtains, for example, a personal guarantee of the Chinese founder backed by assets outside China, governed by New York or Hong Kong law and providing for arbitration in Hong Kong as a dispute resolution venue. Such a guarantee, however, is rarely available (because the Chinese founder may not have assets outside China), and even when potentially available, is often unacceptable to the founder. A more realistic alternative is for a private equity investor to seek the right to appoint a trusted nominee in a chief financial officer or similar position (who could monitor an investee company's financial dealings and compliance with its covenants to its shareholders). An investor may also seek co-signatory rights over the target company's bank account, in which case an independent third party (the bank) will ensure that funds are not released other than for purposes agreed to by the investor.
Among the US-listed going-private transactions that closed during 2017 and 2018, the parties took an average of five months from the announcement of the going-private proposal to reach definitive agreement, and a further three months on average from signing the definitive agreement to close the transaction. Typically, the pre-signing timetable is less predictable and to a large extent driven by negotiation dynamics, the finalisation of the members of the buyer consortium, arrangement of financing and the parties' willingness to consummate the deal, which in turn is affected by market conditions, availability of equity and debt financing, and various other factors. On the other hand, the post-signing timetable is typically largely driven by the SEC review process and shareholders' meeting schedule, and as a result is relatively more predictable. That being said, the going-private of Shanda Games took more than seven months from the signing of the definitive agreement to close, substantially longer than what is typically required of the SEC review and shareholder approval processes, because of, inter alia, changes in the composition of the buyer consortium after signing. The going-private of Qihoo and Xueda Education each also took more than seven months from the signing of the definitive agreement to close, reportedly because of the procedures required to obtain outbound investment regulatory approvals, to complete the conversion of renminbi financing into US dollars offshore and to complete other governmental formalities relating to relevant Chinese onshore buyers. While these are more exceptions than the norm, these transactions do flag for market participants the significant time and resource commitments required of participants in a going-private transaction, and the ever-changing dynamics of market demand and within the buyer consortium (including the time to have all the necessary funds in place), all of which are factors that could affect the timetable to completion.
At the forefront of the privatisation wave in the US and Chinese markets, Focus Media achieved a 45.7 billion yuan backdoor listing on the Shenzhen Stock Exchange in December 2015 through Hedy Holding Co Ltd after a reverse merger, which followed Focus Media's 2013 going-private and de-listing from the United States led by a consortium of private equity investors. This deal represented the first re-listing of a once-NASDAQ listed company on the A-share market, and has blazed a trail for US-listed Chinese companies seeking to go private and thereafter relist in Chinese domestic market. Giant Interactive achieved an 13.1 billion yuan backdoor listing on the Shenzhen Stock Exchange in April 2016 through Chongqing New Century Cruise Co Ltd after a reverse merger, which followed Giant Interactive's 2014 going-private and de-listing from the US led by a consortium consisting of Giant Interactive's chair Shi Yuzhu and private equity investors, including Baring Private Equity Asia, Hony Capital and CDH Investments, making Giant Interactive the first once-US listed Chinese online game company getting relisted on the A-share market. Qihoo, after its largest going-private of a US-listed Chinese company to date, has received the Chinese securities regulatory authority's approval for a relisting in China under the new name of Technology 360 through back-door listing via Shanghai-listed Jiang Nan Jia Jie (SJEC).
As US listings of Chinese companies picked up in 2016, the Shanghai-based logistics company ZTO Express, backed by Sequoia Capital as an early stage investor and Warburg Pincus, Hillhouse Capital Group, Gopher Asset and Standard Chartered Private Equity, who invested in the Series A financing of the company in 2015, raised US$1.4 billion in its listing on NYSE in October 2016, making it the largest IPO by a Chinese company in the United States in 2016, and after Alibaba, the second-largest in history for US IPOs of Chinese companies.
Another noteworthy IPO was the IPO of Beijing Baofeng Technology Co, Ltd on the Shenzhen Stock Exchange in 2015, which became the first-ever listing of a Chinese internet company on China's A-share market after phasing out its VIE structure, and trailblazing a trend of Chinese technology companies tearing down VIE structures and seeking to be listed on Chinese or Hong Kong stock exchanges.
IV REGULATORY DEVELOPMENTS
i Amendment to the Foreign Investment Catalogue
On 28 June 2018, the NDRC and MOFCOM jointly issued the Foreign Investment Negative List, which took effect on 28 July 2018, and repealed in part, on the same date, the previous Foreign Investment Catalogue (revised in 2017). The Foreign Investment Catalogue (including the 2017 and previous versions) categorised industries as encouraged, permitted, restricted or prohibited for foreign investment, while the 2018 Foreign Investment Catalogue lists only those industries subject to special management measures for foreign investment access, including 48 restricted or prohibited industries. Foreign investors in industries not listed in the Foreign Investment Negative List will be treated equally with Chinese investors in terms of market access. The Foreign Investment Negative List reduces the number of industries restricted and prohibited for foreign investments from 63 (in the 2017 Catalogue) to 48, further loosening restrictions on market access, as well as announcing 22 opening-up measures in various industries, including finance, transportation, professional services, infrastructure, energy, resources and agriculture. Here are the key changes in some of the sectors that were the subject of particular focus:
- in the financial services sector, the restrictions on foreign shareholding in domestic banks are eliminated, and the cap on foreign shareholding in securities companies, fund management companies, futures companies and life insurance companies is raised to 51 per cent;
- in the agricultural sector, the restriction on foreign shareholding in the production of seeds of agricultural crops (except the seeds of wheat and corns) is eliminated;
- in the infrastructural facilities sector, the restriction on foreign shareholding in the construction and operation of freight railway lines and railway passenger transport companies is eliminated;
- in the transportation and logistics sector, the restriction on foreign shareholding in the design, building and repair of vessels, international marine transportation, and international ship agency is eliminated;
- in the commercial and trading sector, the restriction on foreign investment in the construction and operation of gas stations, and in wholesale and retail business in rice, wheat and corns is eliminated; and
- in the cultural sector, the prohibition on foreign investment in internet cafes is eliminated.
The Foreign Investment Negative List also sets out a road map and timetable for further opening up of the financial services and automobile sectors in the next few years. According to these provisions, all foreign shareholding restrictions in the financial services sector will be lifted by 2021; foreign shareholding restrictions on the manufacturing of commercial vehicles and passenger vehicles will be lifted by 2020 and 2022 respectively; and the current restriction on foreign investors establishing more than two joint ventures manufacturing the same category of whole-vehicle products will also be removed by 2022.
ii MOFCOM record-filing regime in regulating FIEs
On 3 September 2016, the Standing Committee of the National People's Congress of the PRC adopted a decision to amend and restate four Chinese FIE laws, including the Law on Wholly Foreign-Owned Enterprises (which applies to WFOEs), the Law on Sino-Foreign Equity Joint Ventures (which applies to EJVs), the Law on Sino-Foreign Cooperative Joint Ventures (which applies to CJVs) and the Law on the Protection of Investment of Taiwan Compatriots. These amendments took effect on 1 October 2016. These amendments replaced the previous MOFCOM approval requirements with a record-filing regime nationwide for all FIEs that are not subject to 'national market access restrictions' (which refers to the prohibited and restricted categories in the 2015 Foreign Investment Catalogue as well as any encouraged categories with minimum Chinese shareholding or senior management nationality requirements) in respect of:
- WFOEs' establishment, consolidation, divestiture, extension of term and other key corporate changes;
- EJVs' joint venture contracts, articles of association, extension of term and early termination;
- CJVs' cooperative contracts, articles of association, extension of term, transfer of joint venture interest and designation of third-party management; and
- establishment of enterprises invested in by Taiwan compatriots.
On 8 October 2016, MOFCOM promulgated the Provisional Measures for Record-filing Administration of the Establishment and Changes of FIEs (MOFCOM Order  No. 3) (the FIE Record-Filing Rules), which took effect on the same date. The FIE Record-Filing Rules set out the procedures of the new record-filing regime to replace the approval regime for applicable foreign investment and FIE matters. The filing regime is applicable to the incorporation of FIEs and filings of FIEs' corporate changes, except for matters that are subject to national market access restrictions. Filings shall be made through MOFCOM's online Foreign Investment Integrated Administration Information System.
On 30 July 2017, MOFCOM amended the FIE Record-Filing Rules so that the FIE record-filing regime will apply to general mergers and acquisitions of non-FIE domestic enterprises by foreign investors, as well as to strategic investments in Chinese-listed companies by foreign investors, provided that the investments do not trigger special administration measures and do not involve related-party acquisitions.
On 30 June 2018, MOFCOM further amended the FIE Record-Filing Rules. The new rules took one step further than the previous regulations in streamlining foreign investment regulatory procedures: filings with MOFCOM and SAMR required for establishing or making any material corporate changes to a foreign-invested enterprise will now be made together. Under the new regime, the information required for the MOFCOM filing shall be submitted to SAMR pursuant to the regular registration procedure at SAMR, after which SAMR will forward the information to MOFCOM for it to complete its filing procedure. The applicants therefore no longer have to submit two separate filings with substantially similar information. However, this new filing regime has yet to be implemented in practice.
iii Pilot free trade zones and the Negative List market entry system
On 28 December 2014, the Standing Committee of the National People's Congress of the PRC promulgated new rules to establish pilot FTZs in Guangdong, Tianjin and Fujian, and to expand the area of the current China (Shanghai) pilot FTZ. The new rules took effect on 1 March 2015. Under the new rules, the current MOFCOM approval requirements for the following matters would become simplified filing requirements in the FTZs:
- FIE formation;
- extension of FIE operation terms;
- division, merger or other material changes for WFOE;
- dissolution of an equity joint venture (EJV);
- material changes to joint venture contracts and articles of association for a cooperative joint venture (CJV); and
- transfers of interests in a CJV or entrusted management of a CJV.
Thereafter, several new rules have been promulgated to streamline regulatory approval requirements or relax foreign investment restrictions in the FTZs, including the following developments.
On 19 October 2015, the State Council issued the Opinion on the Implementation of the Negative List Market Entry System. The Opinion reflects the Negative List approach that was first applied in China (Shanghai) Pilot Free Trade Zone, and that was later introduced to pilot free trade zones in Guangdong, Fujian and Tianjin.
On 31 March 2017, the State Council released overall plans for launching seven new free trade zones in Chongqing Municipality and the provinces of Henan, Hubei, Liaoning, Shaanxi, Sichuan and Zhejiang. On the same date, the State Council issued the Plan for the Comprehensive Deepening of the Reform and Opening-up of the China (Shanghai) Pilot Free Trade Zone, which lists 25 initiatives for the Shanghai FTZ, including an initiative to reform the company registration regime, such as removing the company name reservation process, optimising domicile and business scope registration and facilitating de-registration. On 24 September 2018, the State Council released the Notice by the State Council of Issuing the Framework Plan for China (Hainan) Pilot Free Trade Zone.
On 30 June 2018, the State Council issued Special Administrative Measures (Negative List) on Foreign Investment Access to the Pilot Free Trade Zone (2018) (the 2018 FTZ Negative List), which is the fifth version of the FTZ Negative List and took effect from 30 July 2018. The 2018 FTZ Negative List, which applies to the 12 pilot FTZs, from Shanghai to Hainan, contains 45 restricted and prohibited sectors, and further opens up certain sectors that are still restricted or prohibited under the Foreign Investment Negative List. The 2018 FTZ Negative List is a foreign investment list that sets out the foreign investment entry requirements for listed sectors not subject to national treatment with domestic investment in FTZs. Compared with its 2017 counterpart, the 2018 FTZ Negative List further deleted 50 restrictive measures in several industries. It is expected that the FTZ Negative List will continue to be the benchmark for future amendments of the Foreign Investment Negative List. The 2018 FTZ Negative List is slightly shorter than the Foreign Investment Negative List. In addition to the relaxation of foreign investment restrictions in the Foreign Investment Negative List as outlined above, the 2018 FTZ Negative List further relaxes the foreign investment restrictions in the following sectors as follows:
- the permitted foreign shareholding in the selection and breeding of new varieties of wheat and corn is increased from 49 per cent to 66 per cent;
- the joint venture requirement for the exploration and development of oil and natural gas is eliminated, and the prohibition on foreign investment in the exploration, exploitation and ore dressing of radioactive minerals is also eliminated;
- the foreign shareholding restriction on agencies for shows and performances is eliminated, and the establishment of performing arts groups is now open to foreign investment, but the majority stake should be held by Chinese shareholders; and
- the pilot policies in respect of value-added telecommunications (e.g., allowing foreign investment in call centre services, domestic multiparty communications services, internet access services and domestic internet virtual private network services subject to certain foreign shareholding limitations) currently adopted in the original area of the China (Shanghai) pilot FTZ will be introduced to all the other FTZs across the country
iii Outbound direct investment regulatory regime
The Chinese government promotes what it considers to be a healthy and sustainable development of outbound investments. Genuine and lawful outbound direct investment (ODI) deals continue to be supported, but the authorities on various levels have recently tightened the scrutiny of their authenticity and compliance. While genuine and lawful ODI transactions continue to be generally viable, delays in the outbound remittance of funds have increased. In addition, the regulators are closely monitoring certain types of restricted ODI deals, as set out above, and have reminded Chinese companies to make 'prudent' decisions. Under both ODI approval and filing procedures (see NDRC approval and filing with MOFCOM above), investors are required to provide a substantial amount of documentation and information to various authorities, and in both procedures the authorities have a certain degree of discretion in deciding whether to grant an approval or accept a filing. Chinese companies and their business partners should also keep in mind that material changes in an existing outbound investment shall be reported and may trigger another round of review by Chinese authorities.
In light of increased scrutiny by regulators in both the United States and China, foreign private equity investors in China continue to increase their focus on rigorous pre-transaction anti-corruption due diligence, taking steps to ensure that any improper conduct has ceased prior to closing and implementing robust compliance policies after closing. In high-risk scenarios, such as transactions involving companies where significant government interactions are necessary for their operations, the process can be complex and expensive.
Looking forward into 2019, we expect several key factors to impact the level of dealmaking activities for the year as compared to 2018. One key theme of the region going into 2019 is the extent to which, and in what sectors and geographical regions, China will maintain its economic growth. The intensification of the US–China trade war and the competition between the United States and China in other key commercial areas, combined with an increasingly tightened EU foreign investment-screening framework (which is currently the subject of draft legislation), will also make outbound investment transactions by Chinese investors more challenging. Foreign exchange control policy and availability will continue to play a significant role in leveraging the competitiveness of Chinese investors' participation in bidding for overseas assets, and will impact capital inflow and outflow. On the other hand, as China continues to broaden access to its market by foreign investors and improve the foreign investment environment, certain investors may find new opportunities in the reorganisation, consolidation and restructuring of SOEs, listed companies, financial institutions and top-notch start-up firms. However, other investors may shy away from dealmaking because of increased uncertainty in some traditional industries or over-leveraged sectors where the country's regulators may look to curb excessive capital inflow. Key industries such as information technology, healthcare, education and financial services are likely to become the driving forces from which significant transactions can be generated. Major technology companies such as Baidu, Alibaba and Tencent will continue to lead the way in industry, upgrading and consolidating given their active M&A appetite and the inherent need for sustainable growth. The regulatory landscape is also a key factor that may impact investment patterns. With a number of important legal and regulatory developments affecting businesses in mainland China having been launched in 2018, the implementation of these legal and regulatory changes may bring in significant changes, not only in how business models are selected, but also in how they will evolve. For certain industries or sectors where national security, data protection or individual privacy is involved, the regulatory authorities may roll out new measures to ensure that appropriate protection mechanisms will be put into place. In other traditional sectors where foreign investors' majority ownership is permitted for the first time, such as securities firms, life insurance companies and financial asset management companies, private equity investors could find new investment targets or collaborative opportunities for major transactions.
Following the IPO boom in both the United States and Hong Kong in 2018, 2019 is expected to be another strong year for IPO exits in overseas stock markets, but continued difficulties for companies seeking to list in the domestic A-share listings may present challenges for companies looking to be listed domestically. While the Chinese domestic securities market has endeavoured to provide more flexible channels for companies to list on the A-share market (including the launch of a 'registration-based IPO system' to be piloted by the Technology Innovation Board of the Shanghai Stock Exchange) the effects of this pilot programme remain to be assessed. Offshore banks and credit funds could regain their main role in financing M&A activities in the region in general, given the decreased lending capacity of Chinese banks with respect to offshore transactions and the regulators' overhaul of the outbound investment regime (including with respect to capital outflow). One increasingly common deal structure to note is the consortium formed by private equity funds together with strategic investors, especially public companies, in regional and international dealmaking. These are already playing major roles in a number of recently signed or closed transactions, such as the proposed US$6.4 billion acquisition of Amer Sports, in which an investor consortium consisting of FountainVest Partners, ANTA Sports Products Limited, an affiliate of Chip Wilson (founder of Lululemon Athletica Inc) and Tencent Holdings made a voluntary public tender offer for all the shares in Amer Sports Corporation. Not only do the private equity funds complement strategic investors' industry knowledge with their expertise in valuation and deal execution, but they themselves also benefit from the readily available exit opportunity provided by their strategic partners; the prevalence of this consortium structure in the market is likely to further increase.
While going-private transactions involving Chinese companies listed in the United States have significantly slowed down, there have been quite a number of going-private transactions involving Chinese companies listed in the Hong Kong Stock Exchange and the Singapore Exchange, and there could be increased market attention in 2019 on going-privates or takeovers of Chinese companies listed on these capital markets. Two remarkable transactions heading the trend of Hong Kong-listed companies going private were Blackstone's US$322.6 million takeover of property and construction group Tysan Holdings, which was launched in August 2013 and closed in January 2014, and Carlyle's take-private of Asia Satellite Telecommunications Holdings Ltd, where Carlyle agreed to buy out General Electric's 74 per cent stake in the company for up to US$483 million, which was launched in December 2014 and closed in May 2015. In May 2016, Hong Kong-listed Wanda Commercial Properties' controlling shareholder, Dalian Wanda Group, on behalf of the joint offerors, including Pohua JT Private Equity Fund LP, Ping An of China Securities and Shanghai Sailing Boda Kegang Business Consulting LLP, made an offer valued at US$4.4 billion for the going-private of Wanda Commercial Properties, as the largest going-private offer in the history of the Hong Kong Stock Exchange. The deal was completed and Wanda Commercial Properties was delisted from the Hong Kong Stock Exchange in September 2016. A highlight of Chinese investors' take-private of a Singapore-listed company was the purchase of the Singapore-listed Global Logistic Properties (GLP), the largest warehouse operator in Asia, at US$11.6 billion, by a Chinese private equity consortium led by Chinese private equity firm Hopu Investment Management, Hillhouse Capital Group, Chinese property developer Vanke Group and the Bank of China Group Investment, supported by GLP Chief Executive Ming Mei: the deal was completed in early 2018. Market participants also continue to monitor court decisions in the Cayman Islands regarding dissenting shareholders, and how such decisions may further shape both the merger regime in that jurisdiction, where many Chinese companies listed overseas are incorporated, and the broader going-private market.
1 Xiaoxi Lin, Han Gao and Rongjing Zhao are partners at Kirkland & Ellis International LLP. The authors wish to give special thanks to Jiayi Wang and Zhiyuan Gu for their significant contributions to this chapter, and to other Kirkland & Ellis Asia colleagues Pierre Arsenault, Daniel Dusek, David Patrick Eich, Chuan Li, Gary Li, Jesse Sheley, David Zhang, Tiana Zhang, Agnes Li and Jodi Wu for contributing to this chapter.
2 These rules include the Certain Provisions on Change of the Equity Interests of the Investors of a Foreign-Invested Enterprise, the Provisions of the Ministry of Foreign Trade and Economic Cooperation and the State Administration for Industry and Commerce on Merger and Division of Foreign-Invested Enterprises, and the Interim Provisions on Investment Made by Foreign-Invested Enterprises in China.
4 17 November 2016, 'JP Morgan Chase Paying $264 Million to Settle FCPA Charges', Rel. No. 2016-241, available at https://www.sec.gov/news/pressrelease/2016-241.html.
5 In a typical RTO, a private company merges with a publicly traded company (often a shell having limited assets and operations at the time of the RTO), whereby the private company injects its assets into the public company and the shareholders of the private company become controlling shareholders of the public company. As a result of the merger, the (formerly) private company's business essentially becomes listed without that company having paid the cost or gone through the vigorous vetting process or fulfilled the burdensome disclosure requirements of an IPO.