The total value of Chinese companies’ overseas investments has now exceeded US$1 trillion – most of this attributable to central state-owned enterprises and their subsidiaries. China is reforming its regulatory regime to enable substantial outbound investment in a more transparent, flexible environment.
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The SASAC Rules
State-owned enterprises (SOEs) are the powerhouse of China’s outbound investment.
The Government exercises supervisory rights over the performance of SOEs through the SASAC: the State-owned Assets Supervision and Administration Commission of the State Council. There are two main levels of SASAC, being the central SASAC which supervises 117 central SOEs and the provincial SASAC which supervises SOEs incorporated within the relevant administrative region. Unless otherwise specified, the term “SASAC” used in this article refers to the central SASAC.
In 2011, the SASAC published new rules focusing on overseas state-owned assets (ie the “rights or interests constituted by any form of offshore investment made by central SOEs or their subsidiaries”) as follows:
- Interim measures for the supervision and administration of overseas State-owned assets of central State-owned Enterprises (Rule 26)
- Interim measures for the administration of overseas property rights of State-owned Enterprises (Rule 27)
- A circular on enhancing the administration of central SOEs’ overseas property rights  (Circular 114).
(together, the SASAC Rules)
Rule 26 and Rule 27 took effect on 1 July 2011 and Circular 114 took effect on 29 September 2011. The SASAC Rules apply specifically to central SOEs, but the provincial SASACs will probably issue similar rules governing local SOEs. This has already happened in Sichuan province.
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Risk control measures
The SASAC Rules do not impose any substantial approval requirements with respect to central SOEs’ overseas investments in addition to those already in place (in rules published in 2006 [No. 16] and 2008 [No. 225]). Most of the decision-making or supervisory power is still vested with the central SOEs: the SASAC reserves its supervisory power for a limited range of circumstances. Central SOEs are free to decide on and to implement any overseas investment plans within their primary business sector. They have to include these in their annual investment plans (filed with the SASAC) and keep the SASAC informed of any additional investment within the primary business sector but outside the filed plan, and of any correspondence with other regulatory authorities such as the NDRC (the National Development and Reform Commission) and MOFCOM (the Ministry of Commerce). SASAC approval is only required for overseas investment which falls outside the primary business scope of that particular SOE.
On the other hand, there are certain requirements in the SASAC Rules as set out below that worth attention in the context of outbound M&A transaction:
- Approval/filing requirements
Under the SASAC Rules, any merger or acquisition of an overseas listed company, or any material overseas investment by a central SOE or its major subsidiary, must be filed with or approved by SASAC (article 7, Rule 26).
Unfortunately, the terms material investment and major subsidiary are not defined; the criteria for filing or approval are also unclear.
2. Due diligence and valuation
Feasibility studies and due diligence are required for all overseas investments (article 8, Rule 26).
Where onshore state-owned assets are used as consideration for overseas investments or transfer, an appraisal conducted by a domestic valuation institution is required and the results filed with or approved by the SASAC (article 9, Rule 27).
Where an offshore subsidiary of a central SOE, or its subsidiary, either purchases or sells overseas assets, invests with its non-cash assets or changes its shareholding in a non-listed company, a professional institution with the “necessary qualification” and with the right level of “expertise and good reputation” must be engaged to conduct a valuation or appraisal and the results filed with the central SOE (article 6, Circular 114).
If any transaction is likely to result in a reduction of state ownership (such as the loss of controlling ownership), the appraisal findings must be filed with or approved by the SASAC (article 10, Rule 27) – but again, the criteria for filing or approval are unclear.
Were any such transaction to proceed, the transaction price must be based on the appraisal findings.
The rule governing the valuation of state-owned assets located within mainland China dates back to 1991 (No.91). It stipulates that the appraisal be conducted by an institution (not necessarily independent) that has been validated by SASAC. These – excluding the Big Four accounting firms – are typically asset appraisers, accounting/auditing firms or financial consultancy firms.
There is confusion over what kind of professional institution is qualified to evaluate overseas assets under the SASAC Rules; this stems from the lack of clarity around “necessary qualification” and “expertise and good reputation”. (This confusion does not exist with domestic state-owned asset rules.)
There is a perception that SOEs use the valuation reports provided by their financial advisers as a guide when evaluating offshore target assets. This may not be the full picture. The extent to which SOEs rely on financial advisers or their valuations differs among enterprises; it is not uncommon for there to be no financial adviser on some transactions.
Will the SASAC in the future administer the appraisal institution responsible for evaluating offshore assets using an approach similar to that adopted for onshore state-owned assets? Or will a more stringent approach be taken, requiring mandatory appraisal by an independent third party? This remains to be seen. Detailed implementation rules have yet to be released, and the requirements listed above simply reiterate the existing legal regime governing outbound transactions and state-owned assets – but with a clearer signal of the importance of the role of an external professional agency. From a risk control perspective, this also suggests the recognition of a need for solid ground to justify substantial investments before central SOEs spend money overseas.
3. Debt funding
Central SOEs’ offshore subsidiaries cannot provide any form of financing, funding or security to any individual or entity not in the same corporate group, unless they are financial institutions (article 22, Rule 26).
This restriction may raise doubts around pre-completion funding arrangements in acquisitions or in debt financing involving equity (such as convertible notes) under which the target or borrower is not a member of the same corporate group of the SOE until the acquisition is completed or the debt converted to equity.
4. Registration and monitoring of overseas state-owned assets
Any recently obtained overseas state-owned assets must be registered with the SASAC, as must any change to existing overseas state-owned assets (article 8, Rule 27).
A written report covering the administration of overseas state-owned property rights must be submitted to the SASAC by 30 April each year (article 4, Circular 114).
5. Other requirements
We also listed below a few more requirements which are worth noted, though not directly relevant in the context of an outbound M&A transaction.
- Special Purpose Vehicles
The decision to set up an offshore SPV (for the purposes of restructuring, listing, equity transfer or for operational reasons) must be made or approved by the central SOE and reported to the SASAC in writing. Any “unnecessary” SPV must be deregistered (article 11, Rule 26). We have seen rising concerns from central SOEs regarding the incorporation of offshore SPVs as they now need to seriously assess the necessity of having such SPVs for their transactions in light of the obligation to fulfil the “house-keeping” requirements as imposed by the SASAC Rules at a later stage.
- Disposal of offshore assets
The consideration price for the transfer of offshore state-owned assets must, in principle, be paid in one lump sum. If payment has to be made in instalments, the transferee must provide security guaranteeing the outstanding payment. This is important for the disposal (on-sale) by SOEs of their offshore assets after completion of initial acquisitions.
In conclusion, the SASAC Rules are twofold in purpose. They encourage central SOEs – through the establishment of a centralised reporting and control system – to tackle the regulatory vacuum in which their offshore subsidiaries have long operated. They also exert pressure on central SOEs to conduct a complete “housekeeping” exercise to update the central SASAC’s record of offshore state-owned assets.
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Wider reform of regulatory regime
The SASAC Rules are just one of the wider reform measures under review. The SASAC recently stated that it planned to issue more rules regulating outbound investment activities by SOEs in order to promote sustainable development and maintain the value of state-owned assets.
Cross-border transactions are complex, so there is a need for greater clarity in the approval requirements of other authorities, such as the NDRC. In reality, few deals are concluded at the date of signing and there may be subsequent variations (some quite unexpected).
Chinese regulatory approvals are usually granted on fixed terms (based on the terms specified in the first set of signed documents); some terms, however, such as the consideration price, cannot be fixed at the time of signing.
As a result, certain questions arise: does NDRC approval of the initial acquisition cover subsequent equity contributions for the purpose of maintaining debt/equity ratios as required by financiers? Does NDRC approval of purchasing warrants or options also cover the exercise of these instruments? Does NDRC approval of the initial offer cover any subsequent increase of the offer price in a competitive bidding process?
There is a provision in the existing NDRC Rules which requires that any increase to the Chinese party’s original (and approved) investment by 20 per cent or more be submitted to the NDRC for approval (article 15, No.21, 2004). Does this indicate that approved projects therefore include provision for an increase in the investment of anywhere up to 20 per cent? The answer is not clear.
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The lack of clarity of certain regulations can be frustrating. New rules, however, are coming out all the time, providing greater flexibility for outbound investments.
In 2011, the NDRC increased the scope of its local bureaus’ approval authority: it can now authorise transactions up to US$300 million in the resource sector and up to US$100 million in other sectors, thereby hugely accelerating the approval process.
The People’s Bank of China now allows enterprises to make overseas investments in RMB funds and to remit profits from overseas direct investment projects back to China in RMB.
In certain trial areas (like the city of Wenzhou), individual residents are now allowed to make direct investment overseas, following a simplified approval process.
Against a backdrop of global economic turmoil, the Asia Pacific region has proved itself to be resilient. Chinese outbound investment has certainly been a major driver of cross-border flows. In 2011 alone, the volume of China’s non-financial outbound direct investment was US$60.1billion , up from US$59 billion in 2010 and US$47.8 billion in 2009.
Energy and natural resources are key sectors for Chinese outbound investment. We expect to see diversification of deals into other sectors – retail, financial services, autos and other industries – in the coming years.
The new SASAC Rules are a welcome signal, encouraging central state-owned enterprises to “go global” under an increasingly transparent and flexible state-owned assets management regime.
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