KING & WOOD

KING & WOOD

PRC M&A, JV Buyout Seminar PRC M&A, JV Buyout Seminar

Mark SchaubMark SchaubFebruary 13, 2008February 13, 2008

China

M&A

China

M&A

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What’s happening

Completed M&A Deal in China

Year No. of Deals Rank Value (US$m)

2005 668 18,512

2006 616 27,150

2007 715 28,148

Source: Thomson Financial

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China definitely on the radar internationally.

Move from green-field projects to M&A activities.

RMB Appreciation viewed as a given

New sectors opened to foreigners under WTO commitment

HOT areas include:

Why is M&A a hot topic for foreign

investors?

• Automotive

• Machinery

• Pharmaceuticals

• Financial sector

• Retail

• Real Estate

• Construction materials

• Energy

• Mining

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Why a hot topic for Chinese authorities?

Chinese government increasingly fear that foreign companies are taking over the manufacturing base of the country.

Worries exist that Chinese brands and ability of domestic companies to innovate will gradually disappear.

Concerns of local industries that foreigners enjoy monopoly in many industrial sectors, such as light equipment, skincare, beverages, packaging etc.

Stalled projects include Carlyle, Caterpillar, Schaeffler Group

Resentment over CNOOC's failed bid for Unocal.

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I. Legal Framework

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Legal Framework for M&A and JV Buyout

Foreign M&A Rules (08/08/2006)

Takeover Rules of Listed Companies (07/31/2006)

Foreign Strategic Investment Rules (12/31/2005)

M&A regulations

Foreign investment laws and regulations

Laws and Implementing Rules on CJV, EJV, WFOE

Revised Foreign Investment Industrial Catalogue

(10/31/2007)

NDRC Foreign Investment Projects Approval Procedures

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Legal Framework for M&A and JV Buyout—Cont’d

FIE Merger and Division Provisions (11/22/2001)

Investor’s Equity Change Provisions (05/28/1997)

FIE Liquidation Measures (07/09/1996)

JV buyout regulations

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Endorsed by 6 Chinese regulatory bodies: MOFCOM, SASAC, SAIC, STA, CSRC, SAFE

Good news Approval requirements and procedures clearly spelt out.

Chinese government and companies more experienced in M&A transactions.

Opens the door to acquisition by share swaps.

Not so good news New limitations and restrictions imposed.

Approval authorities granted with wide discretionary power.

New Milestone - M&A Rules

Most comprehensive M&A regulations in China to date.

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Broad scope of applicability may have sweeping impacts. Possible key industries:

National Economic Security Concerns

Any deal involving a key industry or famous brand, or may affect national

economic security shall be filed with MOFCOM (Article 12)

• nuclear power

• machinery

• shipbuilding

• military

• power generation/transmission

• steel

MOFCOM may stop a deal it has grounds to believe that it will affect

national economic security – similar to US CFIUS review.

Vagueness in rules escalates uncertainty in deals.

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All share swaps subject to approval by MOFCOM

Offshore entity must be listed in stock exchange.

MOFCOM approval is valid for 6 months only - share swap must be completed in the specified time period.

Onshore share transfer will be reversed if the MOFCOM approval lapse.

SPV may be used to list PRC assets offshore – “small red chip”

A number of PRC governmental approvals required: MOFCOM, CSRC and SAFE

“small red chip” became much more restrictive if not impossible

Proceeds of offshore listing must repatriated.

Share Swap

Share swap is permitted as a M&A tool for the first time in China.

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Identify target

Signing term sheet

Due diligence

Contract drafting

Negotiation

Definitive agreements

Negotiation

SASAC approval

Industrial departments

MOFCOM approval

Anti-trust filing

Business license

SAFE approval

Approval

Conditions precedent

Pre-closing audit /

due diligence

Closing / Payment

Post-closing

integration

Closing

M&A Roadmap

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2007 Foreign Investment Catalogue The Foreign Investment Catalogue lists industries that are encouraged, restricted or

prohibited for foreign investors and is updated by NDRC and MOFCOM from time to time to reflect government policy.

The 2007 Catalogue has been effective as of 1 December 2007.

Encouraged sectors expanded to include more high-tech, energy-saving and environmental friendly industries.

Service sector further opened to foreign investment: such as financing services, logistic and service outsourcing industry .

Exploration of mineral resources and raw materials of strategic importance is more restricted.

Export oriented manufacturing no longer encouraged.

Foreign investment in real estate more restricted.

Media and broadcasting (incl. news website, news agency, internet entertainment etc.) totally prohibited.

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II. Due Diligence

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Types of Due Diligence

Legal - carried out by law firms checking the legal status of Chinese target’s i.e. 1) ownership structure; 2) assets; 3) operation; 4) staff and personnel

Financial - carried out by accountancy firms to check compliance with accounting and financial requirements (some overlap)

Investigatory - carried out by investigation firms to check bone fides of other side

Environmental - carried out by expert consultants

Due Diligence - Procedure

Meet with client

Understand project

Draft

strategy paper

Preparation for field work

Field work

Draft report Follow up

Draft transaction documentation

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III. Structure

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M&A Transactions in China

Share/Asset transfer effective only upon approval NOT signing

Governing law for transfer agreement must be PRC law

Price must be based on appraisal by independent valuator

Payment terms shall comply with mandatory terms:

60% within six months

Remainder within one year

Major forms of transaction:

Share Acquisition

Assets Acquisition

China is still highly regulated in M&A transactions.

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Buyer will take over all business, assets, liabilities of the target.

Careful due diligence is a must - pre-closing restructuring may be

required.

Share deal may be achieved through:

• share purchase from current shareholders

• subscribe to an increase in equity of the target

• share swap

Share Deal

Target

Foreign Investor SellerShare transfer

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Background: A foreign energy company (“Foreign Co.”) intends to

acquire the retail energy business of a domestic energy company in

eastern China (“China Co.”) . China Co. has 2 subsidiaries and over

50 branches over 3 provinces.

Factors considered after due diligence:

Case Study (I)

Purchase Share Purchase Assets

• No need to re-issue operational licenses.

• New operational licenses will need to be issued to the New Co.

• No need to change existing contracts

• Existing contracts should be re-entered by the New Co.

• Inherit existing liabilities of China Co. • Liabilities limited to the purchased assets.

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Factors to be considered based on the due diligence:

Case Study (I)—Cont’d

Purchase Share Purchase Assets

• Accept the existing employees • Select accepted employees, trigger severance

Final decision—client decided for Share Deal because:

• The existing liabilities of China Co. were found to be at an acceptable

level.

• Pre-issuance of license would lead to massive disruption of the

business.

• Payment in installment against milestones to reduce risks.

• Share pledge by Chinese partner as security

• Chinese partner would need to stay in the JV

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Diagram of Share Deal

Foreign Co.Foreign Co.

China Co.China Co.

Subsidiary ASubsidiary A Subsidiary BSubsidiary B

Chinese PartnerChinese PartnerShare transfer 50%Share transfer 50%

50% shareholder50% shareholder

BranchBranch

BranchBranch

BranchBranch

BranchBranch

BranchBranch

BranchBranch

• Business continued

• Closing much easier

• Operational license

remained in place

• Liabilities remained in

company

• Business continued

• Closing much easier

• Operational license

remained in place

• Liabilities remained in

company

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An onshore vehicle is required to own and operate asset in China. Complication in transfer all business, customers, contracts, assets

and employees - notification to creditors is required. Encumbrance will need to be discharged before the transfer. Recommended if:

The target has high level of exposure / noncompliance

Only part of the business is desired.

Buying the Assets

Chinese TargetForeign Investor

InvestmentAsset TransferInvestment

Vehicle

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Background: A foreign machine company (“Foreign Co.”) intends to

acquire a domestic machine building company in North-eastern China

(“China Co.”)

Factors to be considered based on the due diligence:

Case Study (II)

Purchase Share Purchase Assets

• No need to re-issue operational licenses (not many).

• New operational licenses should be issued to the New Co.

• No need to change existing contracts

• Existing contracts should be re-entered by the New Co.

• Inherit existing liabilities of China Co. (large loans)

• Liabilities limited to the purchased assets

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Factors to be considered based on the due diligence:

Case Study (II)—Cont’d

Purchase Share Purchase Assets

• Unpaid land grant fee • Not to purchase land

• Accept the existing employees (more than 1,000)

• Select accepted employees; trigger severance

Final decision—Asset Deal because:

• The existing liabilities of China Co. were found to be large in the due

diligence, including loans, land, employees.

• Not difficult to re-apply for new operational licenses.

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Diagram of Assets Deal

Foreign Co.Foreign Co.

WFOEWFOE

China Co.China Co. China InvestorsChina InvestorsAsset Purchase AgreementAsset Purchase Agreement

Various other agreements i.e.

land, patents, transfer of

business, key employee

contracts

Various other agreements i.e.

land, patents, transfer of

business, key employee

contracts• No inherited liabilities

• Clean start

• Difficult and time consuming closing

• Destroyed sense of co-operation between parties

• No inherited liabilities

• Clean start

• Difficult and time consuming closing

• Destroyed sense of co-operation between parties

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No need to transfer title of assets

No need to transfer operational license

More difficult to spin-off undesired assets or liabilities

Structuring the Deal

Generally reduce risks of legal liabilities tracking back to newco

Ownership of all assets and contractual agreements need to be transferred

New operational licenses required

Possibility to cherry pick assets or liability

More favored by lawyers and accountants because less exposure to hidden liability

Inherit all debts and liabilities of target

Favored by business people because less disruption to existing business

Asset Deal Share Deal

++

--

Higher risk that Chinese party will carry

on competing business

Less risk of Chinese party continuing business

as competitor

--

++

++

++

--

--

!!

-- ++

!!

VS.

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JV Buyout in China

Buy out the Chinese partner and transform the JV into a WFOE

Buy out a large proportion of the shareholding of the Chinese

partner, with the Chinese partner remaining as a minority silent

shareholder

Sell shares in the JV to the Chinese partner/other company

Liquidate the JV

Sue the Chinese partner for breach of contract

Walk away, i.e. cease the cooperation

A JV buyout may be realized through the following ways:

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Summary of Different Options

In summary, the pros and cons of the various options are as follows:

Option Pros/Cons

Foreign investor converts the JV into a WFOE

Clean break +

Possibility to move to a better location +

Improve IP protection +

Foreign investor buys

large majority of

shares

Chinese partner is a silent partner only +

Foreign investor improves control +

Chinese partner retains influence –

No clean break –

Possibility for later problems remains –

Possibly delaying inevitable split –

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Summary of Different Options—Cont’d

In summary, the pros and cons of the various options are as follows:

Option Pros/Cons

Chinese partner/other company buys foreign investor out

Probably very low purchase price –

High risk to IP rights –

Foreign investor liquidates

the JV

Clean break, foreign investor can start

again +

Difficult, time-consuming procedure –

Destruction of current business –

Foreign investor sues Chinese partner for breach

Difficult and time consuming –

Destroys current business –

Foreign investor walks away Unlikely to be practical –

Involves risks of breach of contract –

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Background: A foreign company intends to buy out the Chinese

partner and transform the JV into a WFOE.

Factors to be considered:

• Whether a WFOE is permitted under the Industry Guidance

Catalogue

• Relocate the WFOE

• Call option in the JV Contract

• Price determination

• Restructuring of personnel

Case Study (III)

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IV. Being Aware of Problems

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How to deal with non-compliance?

Evidencing ownership of assets

State-owned assets requirements

Labor issues

Anti-trust review

Intellectual property rights protection

Common Problems in M&A

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How to deal with non-compliance

Chinese companies are more used to informal arrangements.

Non-compliance is widespread: labor, tax, social contribution, licenses, IP etc.

Risks shall be assessed from both legal and practical perspectives.

Not surprisingly foreign invested companies are subject to more stringent scrutiny of Chinese government than their local peers.

Regular internal audit is recommended post transaction.

Almost all Chinese companies have variant level of non-compliance.

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Build in Safeguards/Set Guidelines

Management By-Laws

Employment Contracts

Non-Competition covenants

Employee Handbook

On-Going Involvement

Corporate GovernanceNew Company Law improves fiduciary duties but much the

investor can do:

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Ensure HQ involved and exercises oversight Safeguards/Set

Guidelines

Internal audits

Active board

Avoid ethical blindspots

Management guidelines

Fraud PreventionNot a priority for most companies, but a serious and growing

problem in China:

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Land use rights and real property are often problem areas.

• Granted land vs. allocated land

In most cases assets are subject to encumbrances or third party

claims.

Connected party transaction may result in intermingling of

company assets.

Evidencing the Assets

Ownership of assets and properties are often in question.

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State-owned Assets Rules

Mandatory valuation by licensed appraiser firms• Commonly used valuation methodology – replacement value

• Appraisal results must be confirmed by SASAC

Transaction price cannot be lower than 90% of the appraisal results.

Target must be listed in Asset Exchange Center

• Substantial delay in the closing schedule

• Risk that a potential bidder may crash the party

• Standard contracts of the Exchange Center must be used

Disposal of state-owned assets is subject to complicated approval

procedures.

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Labor Issues

An employee settlement plan must be prepared for M&A deal.

Lay-off is to be negotiated with local government.

Labor related costs should be considered in valuation:

Severance pay to laid-off workers

Compensation for change of status

Should be considered in the valuation

Settlement of staff and workers may cause substantial costs to the

transaction.

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Threshold for anti-trust is rather low:

• Turnover of a transaction party in China exceeds RMB 1.5 billion.

• The foreign investor has cumulatively acquired more than 10 domestic enterprises in one year.

• Current market share of a party exceeds 20% in China

• Post-deal market share of a party will exceed 25% in China.

Anti-trust review may also be requested by domestic competitors, government agencies or industrial associations.

Offshore M&A may also be subject to anti-trust filing in China if meeting certain thresholds.

Anti-Trust Filing

So far most anti-trust filings have been procedural, but it is expected to have more teeth.

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Intellectual Property Rights

IP due diligence necessary to assess risks of IP infringement:

Targets using technology to which they are not entitled

Particular risks in export market

Trademarks/patents not properly registered in China

Risk of technology leakage

Chinese partners, employees, competitors

Measures to be installed to avoid technology leakage and protect IP

IP protection in China is better than its reputation.

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Instruments to Lower Risk

Due Diligence – investigate ownership and title over assets,

business, compliance

Closing Conditions – correction measures on basis of due

diligence results

Payment – installments within the mandatory frame

Reps & Warranties – ownership and compliance

Indemnity – any undisclosed liabilities

Unilateral termination – set out triggers, exit

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V. Summary

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M&A is becoming increasingly popular in China.

BUT also becoming increasingly complicated.

Structure the transaction to suit your needs.

Due diligence is a must before any commitment.

Transaction documentation is a key way to limit

exposure

Main Points to Note

“Make it as simple as possible but not any simpler” - Albert Einstein

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Mark Schaub

Partner in the Business Group of King & Wood, specialized in foreign direct investment, M&A, compliance, intellectual property and private equity investment in China. Mark has advised foreign investment projects in major sectors including retail, power, media, internet, renewable energy, transportation, automotive and manufacturing, etc. 

Tel: 0086 21 2412 6300Email: schaub@kingandwood.comWebsite: www.kingandwood.com

www.china-artoflaw.com

Q&AQ&A

46KING & WOOD

Mergers & Acquisitions in China Seminar – February 13, 2008

Clarence Kwan, the National Managing Partner of the U.S. Chinese Services Group for Deloitte & Touche USA LLP moderates the seminar

47KING & WOOD

Mergers & Acquisitions in China Seminar – February 13, 2008

Felix Chang and Harvey Cohen of Dinsmore & Shohl LLP listen in on the conversation