Upon the promulgation of “Notice on Transferring the State-owned Shares and Shares Owned by Legal Persons in Public Listed Companies to Foreign Investors”, “Interim Provisions on Using Foreign Investment to Restructure State-owned Enterprises” and “Interim Provisions on Foreign Investors Acquiring Domestic Enterprises”, the acquisition made by foreign investors are legally protected in the PRC, and this means the systematic barriers for foreign investors to acquire state-owned enterprises in the PRC has been removed.
Previously, foreign direct investment in the PRC is mainly in the way of establishing new foreign invested companies. After the market of merger and acquisition is open to foreign investors, especially when foreign investors are allowed to merger and acquire Chinese state-owned enterprises, the foreign investors who come to China market lately is declined to using the strategy of M&A in order to shorten the discrepancy between them and the companies who invested in the PRC earlier. In this regard, currently merger and acquisition is becoming an important way for China to absorb foreign investment.
However, considering that the full opening of Chinese M&A market to foreign investors is only at the beginning stage, in practice, there are still a lot of problems to be settled. In this essay, we will discuss about some issues in relation to acquisition of a Chinese state-owned enterprise.
I Due diligence investigation at the beginning of acquisition
Generally speaking, as the target of acquisition, the state-owned enterprises always have a very long history, some of them have been operated for several decades and even more than one hundred years. Due to the long history, the business condition, personnel and external credits and debts of such enterprises are more complicated than other enterprises. So, it is really important to make due diligence investigation thoroughly prior to acquisition.
The due diligence investigation often consists of the following parts:
1. Basic information of the target enterprise, e.g. the equity structure, qualifications, annual-inspection information of the target and etc..
2. The current operation conditions of the target enterprise.
3. Staff, including the number of staff, posts, payment of the statutory funds. If the target enterprise has been restructured or privatized already, the arrangements and compensations of the staff during restructuring should be noted.
4. Main assets owned by the target, mainly including land use rights, real estates, machine and equipment, trademarks, patents and etc., and if such assets have been mortgaged or pledged or not.
5. External investment of the target, if it has subsidiaries or not and the business conditions of the subsidiaries. Although currently there is no provision in China law on “lifting the corporate veil”, in judicial practice, if an enterprise only has one actual controller, it is possible that the controller should be liable for the debts of the subsidiary (“Provisions on Trial Corporate Disputes Cases”, this is an interpretation of law promulgated by the Supreme People’s Court of the PRC). So it is necessary to do detailed investigation on the external debts of the subsidiaries.
6. Current material contracts.
7. Payment of taxes.
8. Environmental issues.
9. Insurance policies.
10. Unsettled lawsuits, arbitration and administrative penalty.
II Several key issues in acquisition
1. Settlement of credits and debts in the course of acquisition
Due to the long history, the state-owned enterprises as the target of acquisition often have very complicated relationships with their debtors and creditors. Additionally, there may be loopholes of management in some enterprises, so the credits and debts of such targets may be in chaos. Given that the debts and credits of the target would be carried by the new company post acquisition, it becomes important for the buyer to thoroughly review the debts and credits of the target when determining to acquire a state-owned enterprise. Also it is necessary to make a settlement plan for the credits and debts.
In this procedure, the following issues should be noted:
1) Making a list of credits and debts
The buyer may require the shareholders of the target enterprise and the managerial personnel to cooperate with the buyer to check the credits and debts of the target and to make a list of the credits and debts in order to define the total amount of the credits and debts and also get the knowledge of the details. Simultaneously, in order to prevent that there are still other debts that have not been disclosed, it is necessary to require the shareholders of the target to issue a warranty letter to the effect that, except the debts they have been disclosed on the list, no other debts are in existence.
2) Warranty for a third party
The state-owned enterprise as the target of acquisition may have provided warranty for a third party. Considering that some loopholes may be in existence in the management of the enterprise there would be such circumstances that the target provided warranty for a third party’s debt but didn’t list such warranty as contingent liabilities on the accounting books of the enterprise. In such circumstances, the liabilities for the buyer post acquisition would be increased potentially and the benefits of the buyer would also be influenced. More seriously, the normal business of the new enterprise post acquisition would be influenced. So the details of the warranties, including but not limited to the amount, category and the parties being warranted, should be reviewed carefully and it is also necessary to explore the information about the warranties by all means in case of omission. Furthermore, in such circumstance, a warranty letter issued by the shareholder of the enterprise would be useful.
3) Bank loans and the relevant warranties
Due to the state-owned nature and special background of state-owned enterprises, generally there would be bank loans with the mortgage of the land use right, real estate or equipment owned by the enterprises. While checking the assets owned by the enterprise, it is necessary to check whether relevant assets have been mortgaged or pledged to the banks. If the buyer is declined to increase its investment to the enterprise post acquisition, it would be better to reach an agreement with the banks on settling the bank loans and strive for more benefits for the new enterprises post acquisition, at the same time to reduce the liabilities of the new enterprises post acquisition.
2. The arrangement of the staff and relevant labor issues
One of important reasons for state-owned enterprises to use M&A by foreign investment to restructure is to reduce staff and enhance investment profits. However, due to their historic background as state-owned enterprises, they often have a large number of staff more than that they actually need. Thus, another key issue in the course of acquiring such enterprises is how to arrange the staff that the enterprise post acquisition doesn’t need.
Pursuant to the “Interim Provisions on Using Foreign Investment to Restructure State-owned Enterprises”, if the control power of the enterprise post acquisition is transferred to foreign investors or the main operation assets are sold to foreign investors, the plan on arranging staff should be made by the enterprise to be structured or the party who is going to restructure the enterprise, and such plan shall be reviewed and agreed by the congress of staff and workers. The salaries of the staff having not been paid, the funds raised by the staff having not been returned and the statutory funds that have not been paid should be paid off by the enterprise to be restructured using its current assets. Two-way choice shall be carried on between the staff and the enterprise to be restructured. Labor contracts shall be renewably entered or changed by the enterprise post acquisition and the staff who are willing to stay. Compensation shall be paid to the staff whose labor contracts are terminated, and the statutory funds shall be paid in a lump sum for the staff who are transferred to social security institution. All the funds necessary shall be deducted from the net assets of the enterprises to be restructured, or be paid in priority by the institutions who manage state-owned assets or equities from the considerations they obtained by selling the state-owned assets or equities.
However, practically each province and city has promulgated their own rules on staff arrangement during state-owned enterprise restructuring. And there are differences on the arrangement methods and compensation amounts. Taken Changzhou City of Jiangsu Province as an example, many rules and explanations on staff arrangement and compensation standards during state-owned enterprises’ restructuring (restructuring due to M&A by foreign investors included) have been promulgated, such as the “Opinions on Settling the Labor Issues in the course of Restructuring Municipal Enterprises” and the supplementary explanation to the Opinions, “Implementing Rules on Executing the Policy of Adjusting Basic Pension Funds of the enterprises’ Retirees” and so on. Therefore, at the beginning of acquisition, it is necessary to do legal research to the local related rules and policies on how to arrange staff in order to accurately estimate how much the target has to compensate to the staff and what kind of liabilities there would be.
Moreover, it is also notable whether the target enterprise has paid off all the statuary funds for the staff. Pursuant to “Interim Rules on Submitting and Collecting Social Insurance Funds” and “Rules on Managing Housing Reserve Funds”, the statuary funds that should be paid by the enterprises for their staff are basic pension fund, housing reserve fund, basic medical insurance fund and unemployment insurance fund. Some enterprises should also pay birth insurance and employment injury insurance. However, because some enterprises have not been operated and managed properly, it is possible that there would be some funds having not been paid. So it is important for the buyer to visit the local social security institutions to check if the target enterprise has paid all the funds for the staff.
3. Environmental issues
Another key issue in acquisition which foreign investors are often keen to is the environmental issues.
Considering that some target enterprises have a long history and the equipment of waste discharge is often old and even out of order, such enterprises may be punished or fined by the local environment protection authorities. Nevertheless, because sometimes the environmental laws and regulations are not executed strictly by the local environment protection authorities, in some places the penalties to the enterprises that discharged wastes exceedingly are often made randomly, that is, every year they would be fined at an unfixed amount. At the same time, because such enterprises are state-owned, it is unlikely for the local environment protection authorities to punish them seriously. Under such circumstance, it would be doubtful for a foreign buyer when think about the environmental issues. And it is normal for the buyer to worry that it may be borne serious liabilities post acquisition. Therefore, the environmental issues are often deemed as one of the great risks in the course of acquisition by foreign investors and may influence the price of the M&A.
In M&A projects made by foreign investors, the foreign buyers are most concerned about what kinds of liability may be borne by the new enterprise post acquisition and its new legal representative (considering that the legal representative is most likely to be appointed by the buyer when control power in the target enterprise is shifted) for the environmental problems caused by the target enterprise.
According to the environmental protection laws and regulations of China, there are three kinds of legal liabilities caused by environmental pollution: (1) civil compensation liability, that is, to make compensation for the losses of the State or individuals or other organizations suffered from pollution; (2) criminal liability, that is, the person who is mainly and directly liable to the pollution (as regards enterprise, it is usually to be the enterprise’s legal representative) is to be sentenced to no more than seven years of fixed-term imprisonment, criminal detention or fine; (3) administrative penalty, that is, a fine that amounts to one to three times of the waste discharge fee would be imposed.
In the practice, it is common that the enterprises that caused environmental pollution only bear certain administrative penalty, namely a fine, due to discharging waste exceeding the standards. As to criminal liability, the legal representatives of the enterprises that caused environmental pollution may only be held responsible for severe pollution; the present legal representatives usually have no responsibilities for the pollution caused by the enterprises’ business activities before they took the position.
However, in order to eliminate the foreign buyers’ doubt and worry about the environmental issues, it is necessary to perfect the environmental protection laws and regulations and unify the law execution process.
4. The business scope of the target enterprise
The restrict provisions of foreign investment in Chinese laws and regulations should also be noted when foreign investors acquire and merger state-owned enterprises and state-owned enterprises prepare to use foreign investment to restructure. In this regard, it is necessary to examine the business scope of the target enterprise, which is also likely to be ignored in practice.
The “Catalogue Guiding Foreign Investment in Industry” (the Catalogue) divides foreign investment into four categories: encouraged, permitted, restricted, or prohibited. For instance, in an acquisition project we handled, a transnational company intended to acquire a brewery company, whose business scope includes production and sales of rice wine. Pursuant to the Catalogue, foreign investment is restricted in the industry of producing rice wines, however, the foreign buyer would hold the majority shares of the brewery company after acquisition. In this circumstance, the buyer and the target enterprise should consult the examination and approval authorities and other relevant authorities to obtain required approval documents or to amend acquisition plan so that the acquisition can be completed smoothly.
III Conclusion
Multinational corporations are constantly seeking to restructure their businesses via M&A transactions to improve efficiency and profitability. This restructuring can only be effective if it can be accomplished quickly and through reliable procedures. These requirements of international business have been accommodated by Chinese M&A laws in their recent changes. With China's need for more foreign investment and the profound opening of M&A market to foreign investors, Chinese laws and regulations in this respect will definitely become more executive and streamlined.