The Acquisition and Leveraged Finance Review: China
Domestic and international banks are the primary source of debt finance in acquisition transactions. Finance companies also play an important role in the debt financing market. Unsecured credit facility, secured facility, revolving facility for working capital purposes, bonds and convertible bonds are the most commonly used debt products. Chinese laws are not well developed for the mezzanine finance; however, mezzanine finance is not a new concept in China as it is commonly seen for Chinese companies with an offshore structure. For onshore companies, hybrid debt-plus-securities instruments are commonly arranged, under which companies can issue securities backed by the credit assets consisting of the debts arising out of a number of loans of multiple borrowers in the national inter-bank bond market or stock exchanges, and the qualified investors, thus, may be able to negotiate and trade these securities.
Regulatory and tax matters
In China, an entity can only conduct lending business after obtaining the permit or approval by the People's Bank of China, China Banking and Insurance Regulatory Commission (CBIRC) or other competent governmental authorities. Major market players in the debt financing industry are commercial banks, policy-oriented banks, lending companies and micro-lending companies, which should conduct business according to the applicable laws and regulations.
i Acquisition finance
Commercial banks, policy-oriented banks, Chinese branches of foreign banks, finance companies of enterprise groups, while conducting their acquisition finance business, should comply with the Guidelines for Risk Management of Acquisition Financing by Commercial Banks (the Guidelines) promulgated by CBIRC. According to the Guidelines, the financing amount may not exceed 60 per cent of the total acquisition price of a transaction and the term of the loan may not exceed seven years.
According to the Guidelines, a lender conducting acquisition financing business should meet the following requirements: (1) have sound risk management and an efficient internal control mechanism; (2) its capital adequacy ratio is not less than 10 per cent; (3) all of its other regulatory indices meet applicable regulatory requirement; and (4) have a professional team to conduct the due diligence and risk assessment of acquisition financing.
The Guidelines also set forth the requirement for the acquisition financier to maintain the internal control and risk management system, including:
- its aggregate outstanding amount of acquisition financing not exceeding its net tier-1 capital for the same period, and its aggregate outstanding amount of acquisition financing to a single borrower not exceeding 5 per cent of the net tier-1 capital for the same period;
- assessing the strategic, legal, regulatory, concentration, business, financial and regulatory risks of an acquisition transaction;
- reporting to CBIRC the concentration limit on a per-borrower, group customer, industrial, national or jurisdictional basis;
- ascertaining the leveraged ratio of acquisition financing and ensuring reasonable funding by equity contribution;
- strengthened due diligence and after lending loan management and supervision; and
- mandatory provisions in the facility agreement to protect the lender's right, such as the provisions on the lender's right to take risk control measures upon occurrence of material adverse change in the target group and the equity funding as a condition precedent to the disbursement of the acquisition financing.
ii Syndicated loan
The Guidelines for Syndicated Loan Business (the Syndication Guidelines) promulgated by CBIRC are the primary regulations on the syndicated loan business, which stipulate the rights and responsibilities of the lead bank, agent bank and participating bank, form of syndication and documentation requirement. If a single bank acts as the lead bank, its commitments should be not less than 20 per cent of the total commitment, and the participating shares of the other members should not be less than 50 per cent of the total commitment.
iii Anti-money laundering and anti-corruption compliance
The Anti-Money Laundering Law and the Provisions on Anti-Money Laundering of Financial Institutions stipulate the detailed requirement for the financial institutions and certain non-financial institutions to comply with the anti-money laundering obligation, including identifying a client's identity, preservation of information of the clients and transactions and reporting the transactions of large amount or dubious transactions.
In 2017, the People's Bank of China issued a notice to strengthen the scrutiny of identification of a client's identity so as to fight against money laundering and terrorism financing. In the event that the client is a non-individual entity, a financial institution is required to investigate, record and report the current shareholding structure and any change thereof and information on the ultimate parent shareholder and senior management officers. The notice also provides the guidance for strengthening scrutiny if the client is a sensitive individual (e.g., foreign political dignitary, member of senior management of an international organisation or individual beneficially owning the interest of the non-individual client), or is involved in certain type of business relationship (e.g., a client from a high-risk district or countries as identified by FATF, EAG, APG or other international anti-money laundering institutions).
Anti-corruption is largely stipulated in the China's Criminal Law, Anti-unfair Competition Law and related regulations. There is no legislative guidance specifically applicable to the financial institutions regarding administration of anti-corruption matters.
Total interest income is taxable income, and unless otherwise stipulated by law, the taxable income of the enterprises is generally subject to 25 per cent of the corporate income tax in China. The overseas branch office (with no legal person status) of a Chinese resident bank is considered as a resident of China for tax purposes. The income of the overseas branch office is taxable together with its head office, and no withholding tax is payable for the interest paid from a domestic institution to the overseas branch office, provided that, if the overseas branch collects the interest on behalf of a non-Chinese resident, the domestic enterprise is obligated to withhold income tax for the interest paid to the overseas branch. If the actual management organ of a Chinese enterprise's overseas subsidiary is located in China, the overseas subsidiary will be considered as a Chinese resident as well.
Interest expenses are deductible against operating income of the borrower.
The financial institutions are subject to a 6 per cent VAT for the income accrued from the debt financing; if, however, a financial institution is recognised as small-sized taxpayer, the VAT rate is 3 per cent. VAT exemption is granted if the loan is made to small enterprises, micro enterprises or a self-employed household.
Unless otherwise stipulated in the tax treaties or other tax preferential treatment, a Chinese resident borrower should withhold the corporate income tax at the rate of 10 per cent for the interest paid to the non-resident lender.
Security and guarantees
The types of security under Chinese laws include mortgage, pledge, guarantee and lien, among which the security package most commonly used in the acquisition finance transaction are share pledge, cash deposit, corporate or personal guarantee or combination of the foregoing. Mortgage of real estate (including land use right) of great value is also commonly seen, but the practice of registration varies according to different local governmental authorities; mortgages may not be registered in some areas if the beneficiary is a non-bank lender.
Grant of cross-border security or guarantee is subject to the administration of the State Administration of Foreign Exchange (SAFE); for example, the provision of guarantee or security by an onshore non-bank entity in favour of an overseas entity securing the debt of an overseas debtor should be registered with SAFE after the execution of security documents.
In the case of listed company takeover, the listed company should not provide any form of financial assistance to the acquirer, or any security in favour of the acquirer or its affiliate.
Security is irrevocable if it is granted within one year of the court accepting a bankruptcy application with respect to the security provider to secure an unsecured debt.
Priority of claims
Secured claims should be repaid in priority from the proceeds of the secured assets. After full repayment of the secured claims, the remaining amount of the proceeds of the secured assets (if any) will be considered as the bankruptcy assets.
Other claims should be paid in the following orders from the bankruptcy assets:
- administrative fees and expenses in connection with the bankruptcy proceeding, and debts incurred for the common good of creditors after initiation of bankruptcy proceeding;
- wages, subsidies for medical treatment, injuries and disability, and the pensions for the disabled and the families of the deceased which the debtor owes, the basic health and pension benefits that should have been paid to the employees' personal accounts, and other compensations should have been paid to the employees as prescribed by law and regulations;
- other social insurance premiums and tax that the bankrupt fails to pay; and
- unsecured bankrupt claims.
In China, subordinated bonds can only be issued by the securities companies and other financial institutions in accordance with law. While Jiangsu High Court recognises the enforceability of a subordination arrangement in a precedent case, contractual subordination arrangements among unsecured creditors have a lack of legal basis under the Bankruptcy Law; therefore, it is uncommon to see this in practice.
i Governing law
In a domestic transaction, Chinese law should be the governing law of the transaction agreement. In cross-border transactions, the parties may choose the governing law of the transaction agreements. English law, Hong Kong law and New York law are most often chosen by the parties as the governing law of the cross-border credit facility agreement.
In the absence of a choice of law, the court will apply the rules of closest connection to determine the governing law. For example, the law of the jurisdiction in which the lender is located may govern the financing agreement.
There are some exceptions to the parties' freedom of choice of law. Where the collateral is the immovable asset, the law of the jurisdiction where the immovable assets are located should be the governing law of the security agreement. Chinese law mandatorily applies to certain agreements relating to foreign investment in China, such as, for example, share purchase agreements, assets purchase agreements and subscription agreements involving foreign entities, as well as Sino-foreign equity joint venture contracts, Sino-foreign contractual joint venture contracts and contracts for Sino-foreign joint exploration and development of natural resources that will be performed within China.
Generally, the courts will uphold the choice of law provisions as long as such provisions do not violate public policy of China or contradict the mandatory provisions of Chinese law.
If the court determines that the parties intentionally create the ground to apply foreign law to avoid the application of Chinese law, it will not uphold the application of foreign law and Chinese law will apply instead.
ii Recognition of foreign judgment or arbitration award
China is a contracting state of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958).
Where a final and conclusive civil judgment or written order of a foreign court or an arbitral award of a foreign arbitral tribunal is submitted to a Chinese court for recognition and enforcement, it will be reviewed by the court in accordance with the treaty concluded between China and the jurisdiction where the judgment, order or award is made or in accordance with the principle of reciprocity. If the court determines recognition and enforcement does not violate basic principles of Chinese law or is not contrary to the sovereignty, national security or public policy of China, it will recognise the foreign judgment, order or award. In the absence of the treaty or reciprocal relationship, the court will render a ruling to dismiss the application, unless the party concerned applies to the people's court for recognising a legally binding divorce judgment rendered by the foreign court.
Acquisitions of public companies
The Measures on the Administration of Acquisition of Listed Companies (the Acquisition Measures) promulgated by the China Securities Regulatory Commission (CSRC) are the major regulations on the acquisition of public companies. Acquisition of listed companies can be taken through agreement or tender offer.
i Mandatory offer requirement
If the investor, acting alone or jointly with others by agreement, wishes to purchase the shares of the listed company from a third party by agreement, so that the aggregate shares held by such purchaser would exceed 30 per cent, the purchaser shall launch the general tender offer to acquire all the remaining shares of the target company before completion of the purchase by agreement. The purchaser may apply to CSRC for waiving the foregoing tender offer or general tender offer requirement.
If the investor holding more than 30 per cent of the shares of a listed company wishes to further increase its shareholding percentage acting alone or jointly with others by agreement, it should launch the tender offer to acquire all or part of the shares of the target company.
ii Disclosure of the financing terms
The tender offer report should, among others, disclose the term and price of the acquisition, the source of funding required for the acquisition and the guarantee structure in relation thereto. However, the detailed financing terms, including the flex and fees, are not required to be disclosed.
There are no such squeeze-out rules in China. However, in the case of a general tender offer, the purchaser is required to specify in the offer report, among other things, the closing date after delisting and arrangements for the shares held by the remaining shareholders after expiry of the offer period. If, at the end of the offer period, the target company fails to meet the listing requirement (i.e., less than 25 per cent of the shares are held by the public, or the total value of the shares of the target exceeding 400 million yuan, less than 10 per cent of shares are held by the public), the target company should be delisted. If requested by the remaining shareholders, the purchaser should purchase the shares then held by the remaining shareholders within the timeline as provided in the purchaser's offer report on the same terms as the tender offer.
In the case of a tender offer, the purchaser should firstly prepare the offer report and disclose the summary of the offer report in a brief announcement. All the conditions to the offer shall be highlighted in the summary of the report. The offer report will be disclosed after the conditions have been satisfied. Unless otherwise waived by CSRC, the offer report is unconditional.
Chinese law currently does not stipulate the requirement of the conditionality to the offer. Obtainment of the governmental approval is commonly seen as condition in the summary of the offer. There are cases where satisfaction to the due diligence result by the purchaser is the condition in the summary of the offer.
v Form of payment
The purchaser may, by means of cash, securities, or combination of cash and securities, or by other lawful means, pay the purchase price for acquisition of a listed company. In the case of payment in securities, the purchaser should provide audited financial and accounting statements, and securities evaluation report of the issuer of the said securities for the last three years, and should cooperate with the independent financial adviser engaged by the target company in its due diligence investigations. In the case of payment in transferable bonds, the bonds must have been listed in the securities exchange for at least one month. In the case of payment in securities that are not listed in any securities exchange, the purchaser must meanwhile provide the cash payment option for the offerees to choose.
In the case of general tender offer to acquire all the shares of the target company, the consideration should be paid in cash. If the purchaser wishes to pay the consideration by transferable securities, it must, at the same time, also offer the cash payment option for the offerees to choose.
vi Certain funds requirement
The purchaser should provide at least one of the following measures to guarantee the performance:
- in the case of payment of the purchase price in cash, a deposit of not less than 20 per cent of the total consideration to the designated account of securities depository and clearing institution; in the case of payment of purchase price in securities, a deposit equalling the value of all the securities used for payment in the custody of the securities depository and clearing institutions;
- a bank guarantee covering the total purchase price; or
- a written commitment issued by the financial adviser undertaking joint and several liability for payment of consideration.
The financial adviser of the purchase is also required to conduct due diligence on the purchase's capability and source of funds, and to specify whether the purchaser has the ability to complete the tender offer in its report and whether there is any circumstance where the purchaser obtains the financing by way of mortgaging the target shares.
The year in review
While the covid-19 outbreak brought China's cross-border investment to a halt in the first quarter of 2020 and the cross-border activities dropped sharply, the economy has gradually heated up in China since the second quarter and cross-border investment is recovering. Foreign direct investment into China rose 2.6 per cent year-on-year to US$89 billion in the first eight months of 2020. Considering August 2020 only, foreign direct investment volume increased by 15 per cent compared to August 2019.2 This is driven by the continuing opening-up of the Chinese market. A new Foreign Investment Law (the New FDI Law) came into effect on 1 January 2020, replacing the former laws and regulations applicable to foreign investment. The New FDI Law is considered as an effort of Chinese authorities to address the foreign concern and criticism on Chinese openness, by providing more flexibility on joint venture terms and streamlined incorporation procedures, pledging to grant equal treatment to foreign investors as that to their domestic counterparts, access to public procurement, prohibiting Chinese joint-ventue partners from infringing intellectual property and trade secrets, and barring Chinese authorities from forcing technology transfer, etc. To strengthen China's attractiveness for foreign investment, the negative list of industries to bar foreign participation has been shrinking in recent years, and China's 2020 version of the negative lists, which took effect in July, has further reduced the number of sectors that are off limits for foreign investors to 33 from 40 in 2019. On the other hand, the outbound investment volume dropped by 2.1 per cent in the first seven months of 2020 compared to the previous year, while the outbound investment in the Belt and Road Initiative countries increased by 33.2 per cent in the first seven months.3
Furthermore, the Securities Law of the People's Republic of China (the Securities Law) was amended on 28 December 2019, and took effect, as amended, on 1 March 2020, changing the approval system to the registration-based system for initial public offerings and issuance of corporate bonds. The Securities Law enhanced the information disclosure requirements and streamlined the requirements for issuing securities.
The recovery of cross-border activities for the remainder of 2020 is expected, as the economy recovers and new opportunities may be created by market volatility.
To respond to the New FDI Law, local authorities will progressively introduce a series of implementing regulations and directives to implement the changes introduced by the New FDI Law. Foreign investment in China will continue to be boosted, driven by the relaxation of market access.
Due to the tightened control on 'irrational' outflows as well as greater regulatory and political scrutiny confronted by the Chinese investors abroad, the outbound investors will continue to face great challenges in the years to come. However, the investment in strategic assets including high tech, commodities, infrastructure and energy may still be hopeful, which is in line with, for example, the Belt and Road Initiative or depends on the situation of local countries.
1 Xiong Yin and Jie Chai are senior partners and Qin Ma is a partner at Tian Yuan Law Firm.