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Closing the Deal in China: Basic Considerations

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NEWS & INSIGHTS
Publications
24 NOV 2008

Closing The Deal In China: Basic Considerations
ARTICLE MERGERS AND ACQUISITIONS NEWSLETTER

by David M. Pendergast

Getting an M&A deal across the finish line in the People’s Republic of China (PRC) can be a frustratingly slow process for United States companies and legal practitioners. Slow-moving negotiations, language barriers, audits of the PRC company and confusing PRC governmental approval requirements almost always act as speed bumps along the way. This article provides an overview of basic considerations that, if considered ahead of time, will assist in setting realistic timing expectations for efficiently closing a deal in China. The keys to success are to identify, early in the process, the decision makers on the Chinese side; to include in your transaction team people who are business-fluent in English and Chinese; to understand that there will inevitably be delays during the necessary audits; to understand which Chinese regulators will need to approve the deal; and most of all, to retain patience. Identify Decision Makers The first step in every deal in the PRC should be to clearly ascertain who on the PRC side is the ultimate decision maker. In your initial discussions, you may be working with an individual you conclude is the person with final authority over a particular issue, or who even has meaningful knowledge of it; but it is not unusual to learn that this belief is erroneous. Although claiming a lack of authority or knowledge is a common negotiating tactic everywhere in the world, US companies seeking to complete deals in the PRC should not be surprised if such claims are inexplicably made by persons whom one would expect to have authority or knowledge.

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11/26/2008

DLA Piper | Publications | Closing The Deal In China: Basic Considerations

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In some cases, a potential explanation for this situation is that the corporate officer is beholden, even in the management of the affairs of the entity, to a shareholder or parent company that is not directly accessible to the US company. In others, the likely cause seems to be an overly cautious approach born from living in a country where the consequences for getting something wrong have historically been extremely severe. Regardless of the underlying causes, US companies and legal practitioners should expect longer negotiating periods when pursuing deals with PRC partners than they are accustomed to in US transactions. Language Issues Translating the deal adds time and cost to any transaction in China. It is essential to have members of your transaction team who are business-fluent in both English and Mandarin Chinese. Third-party translation services can be an effective means to keep costs down, but all translated legal documents should still be reviewed for accuracy by bilingual lawyers, especially if the English and Chinese versions of the agreement are equally controlling. In addition, although engaging a third-party translation service company can reduce transaction costs, such fees are still relatively expensive. Early in the process, the parties should discuss who will be responsible for the costs of translation. In some cases it can be helpful to have someone on your team who is fluent in another dialect of spoken Chinese. Mandarin Chinese is the language of business in China, but regional languages that are unintelligible to Mandarin speakers abound everywhere. Although it is highly unlikely that a US company would encounter a PRC deal party with principals that do not speak Mandarin, being able to converse in a local dialect such as Shanghainese, Wu, Cantonese or Min can serve to improve the personal relationships of the deal partners, and personal relationships can sometimes be more important to getting a deal done in China than business concerns. Audit Issues Internal accounting records of PRC companies may conform to generally accepted accounting principles of the PRC (PRC GAAP), but such records rarely, if ever, conform with US GAAP. Accordingly, in a transaction where an audit conforming to US GAAP is required, US acquirors should begin the transaction with the expectation that significant time will be required to prepare and audit the PRC company’s financial information in accordance with US GAAP. Ask for accountants’ work papers early, because it will often be true that the supporting material necessary to conduct a US GAAP audit will be deficient. This is particularly true in IPOs or reverse takeovers where the deal cannot get done without a US GAAP audit. Governmental Approvals

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Depending on the nature of the transaction, closing the deal may require approvals from or filings with a myriad of seemingly overlapping local and national PRC governmental regulators. Deal planners should begin their assessment of the extent of necessary approvals by reviewing China’s Foreign Investment Catalogue, which details industries in which acquisitions by foreign entities are restricted, prohibited or encouraged. The three principal national regulators having oversight over cross-border M&A transactions in China are the Ministry of Commerce (MOFCOM), the State Administration of Industry and Commerce (SAIC) and the State Administration of Foreign Exchange (SAFE). Each of MOFCOM, SAIC and SAFE have local (i.e. provincial or city) counterparts that in some cases may have oversight that is in addition to the oversight of MOFCOM, SAIC or SAFE, but generally such additional oversight is substantively identical. MOFCOM approval is required for transactions that qualify as an “equity acquisition” or an “asset acquisition” under China’s M&A regulations, the Provisions on Acquisition of Domestic Enterprises by Foreign Investors, which became effective on September 8, 2006. An “equity acquisition” is either (1) a foreign investor’s purchase of the equity interests of a shareholder in a domestic PRC company, or (2) a foreign investor’s subscription to a domestic company’s capital increase that results in the conversion of the domestic company into a newly established foreigninvested enterprise. An “asset acquisition” is defined to include both (1) a foreign investor’s establishment of a PRC entity and subsequent purchase, through such newly established entity, of the assets of a domestic PRC enterprise and operation of such assets, and (2) a foreign investor’s purchase of the assets of a wholly domestic PRC enterprise and the use of such assets to invest in and establish a new PRC entity to operate such assets. Although some practitioners have structured M&A deals in a way that they believe does not trigger a need for MOFCOM approval under China’s M&A regulations, the more cautious view is that MOFCOM approval is required for every M&A transaction involving a transfer of PRC entities or assets. Also, beginning on August 1, 2008, the PRC’s new Anti-Monopoly Law came into effect. This law created a new division within MOFCOM, called the Anti-Monopoly Enforcement Authority, which is tasked with enforcing the Anti-Monopoly Law in the M&A context and has authority to prohibit mergers and require divestiture of acquisitions that it views as violating the new law. Filings are required under the Anti-Monopoly Law if a foreign acquiror seeks to acquire over 50 percent of a defined market. Due to the recent effectiveness of the Anti-Monopoly Law, its impact on deal timing remains to be seen and China focused legal practitioners are closely watching how it will be implemented and enforced. SAIC is responsible for registering various entities in the PRC and in that regard, is comparable in function to secretaries of state in the US. Prior to conducting business, new companies in the PRC must obtain a business license from SAIC.

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Additionally, foreign invested limited liability companies must list their shareholders in their articles of association and must file an amendment to their articles of association anytime the identity of their equity-holders changes. SAFE’s involvement in the M&A realm arises primarily from its promulgation of Circular 75, “Circular of the State Administration of Foreign Exchange on Relevant Issues concerning Foreign Exchange Administration of Financing and Return Investment Undertaken by Domestic Residents through Overseas Special-Purpose Vehicles.” Although the contours of Circular 75 are beyond the scope of this article, generally speaking, registration with SAFE is required for transactions that involve a “special-purpose vehicle,” which is defined as an overseas enterprise directly established or indirectly controlled by a domestic resident legal person or domestic resident natural person for the purpose of undertaking equity financing abroad with the enterprise assets or rights and interests it/he holds in China. Such special-purpose vehicles are frequently used in Chinese M&A deals. Other governmental regulators from whom approval may be required or to whom notice must be given include the State-owned Assets Supervision and Administration Commission (SASAC) if a transfer of state-owned assets is involved, the China Securities Regulation Commission (CSRC) if a China-listed company is involved and, in extraordinary circumstances, the National Development and Reform Commission (NDRC), which has general supervisory powers over China’s economy and has been the subject of recent news reports regarding a push within China’s government to create a mechanism for vetting foreign acquisitions for national security concerns. Deal planners should expect to spend several months navigating the regulatory approval and notification process. Conclusion Closing an M&A deal in China demands patience and an expectation that progressing from initial negotiations to closing will require more time than is customary in purely US deals. With the assistance of experienced counsel, confronting the challenges discussed above can be done in an effective and efficient manner. An earlier version of this article appeared in Law360 on September 9, 2008.

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