2. PRC M&A, JV Buyout Seminar
Mark Schaub
February 13, 2008
China M&A

3. 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 3

4. Why is M&A a hot topic for foreign investors?
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:
Automotive
Machinery
Pharmaceuticals
Financial sector
Retail
Real Estate
Construction materials
Energy
Mining 4

5. 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.
Resentment over CNOOC's failed bid for Unocal.
Stalled projects include Carlyle, Caterpillar, Schaeffler Group 5

6. I. Legal Framework 6

7. Legal Framework for M&A and JV Buyout
M&A regulations
Foreign M&A Rules (08/08/2006)
Takeover Rules of Listed Companies (07/31/2006)
Foreign Strategic Investment Rules (12/31/2005)
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 7

8. Legal Framework for M&A and JV Buyout—Cont’d
JV buyout regulations
FIE Merger and Division Provisions (11/22/2001)
Investor’s Equity Change Provisions (05/28/1997)
FIE Liquidation Measures (07/09/1996) 8

9. New Milestone - M&A Rules
Most comprehensive M&A regulations in China to date.
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. 9

10. 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)
Broad scope of applicability may have sweeping impacts.
Possible key industries:
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. 10

11. Share Swap
Share swap is permitted as a M&A tool for the first time in China.
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. 11

12. M&A Roadmap Identify target Signing term sheet Due diligence
Contract drafting
Negotiation
Definitive agreements
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 12

13. 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. 13

14. II. Due Diligence 14

15. 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 15

16. Due Diligence - Procedure
Meet with client
Understand project
Draft
strategy paper
Preparation for field work
Field work
Draft report
Follow up
Draft transaction documentation

17. III. Structure 17

18. M&A Transactions in China
China is still highly regulated in M&A transactions.
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 18

19. Share Deal
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
Foreign Investor
Seller
Share transfer
Target 19

20. Case Study (I)
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:
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. 20

21. Case Study (I)—Cont’d
Factors to be considered based on the due diligence:
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 21

22. Diagram of Share Deal Share transfer 50% Foreign Co. Chinese Partner
50% shareholder
China Co.
Business continued
Closing much easier
Operational license remained in place
Liabilities remained in company
Branch
Branch
Branch
Subsidiary A
Subsidiary B
Branch
Branch
Branch 22

23. Buying the Assets
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.
Foreign Investor
Chinese Target
Asset Transfer
Investment
Investment Vehicle 23

24. Case Study (II)
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:
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 24

25. Case Study (II)—Cont’d
Factors to be considered based on the due diligence:
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. 25

26. Diagram of Assets Deal Asset Purchase Agreement Foreign Co. China Co.
China Investors
Various other agreements i.e. land, patents, transfer of business, key employee contracts
WFOE
No inherited liabilities
Clean start
Difficult and time consuming closing
Destroyed sense of co-operation between parties 26

27. Structuring the Deal - - - - - + + + + + ! ! Asset Deal Share Deal 27
VS.
Share Deal +
Generally reduce risks of legal liabilities tracking back to newco -
Inherit all debts and liabilities of target
More difficult to spin-off undesired assets
or liabilities +
Possibility to cherry pick assets or liability - -
New operational licenses required +
No need to transfer operational license
Ownership of all assets and contractual agreements need to be transferred - +
No need to transfer title of assets
Higher risk that Chinese party will carry on competing business
Less risk of Chinese party continuing business as competitor - +
More favored by lawyers and accountants because less exposure to hidden liability ! !
Favored by business people because less disruption to existing business 27

28. JV Buyout in China
A JV buyout may be realized through the following ways:
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 28

29. 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 – 29

30. 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 – 30

31. Case Study (III)
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 31

32. IV. Being Aware of Problems32

33. Common Problems in M&A How to deal with non-compliance?
Evidencing ownership of assets
State-owned assets requirements
Labor issues
Anti-trust review
Intellectual property rights protection 33

34. How to deal with non-compliance
Almost all Chinese companies have variant level of 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. 34

35. Corporate Governance
New Company Law improves fiduciary duties but much the investor can do:
Build in Safeguards/Set Guidelines
Management By-Laws
Employment Contracts
Non-Competition covenants
Employee Handbook
On-Going Involvement 35

36. Fraud Prevention
Not a priority for most companies, but a serious and growing problem in China:
Ensure HQ involved and exercises oversight Safeguards/Set Guidelines
Internal audits
Active board
Avoid ethical blindspots
Management guidelines 36

37. Evidencing the Assets
Ownership of assets and properties are often in question.
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. 37

38. State-owned Assets Rules
Disposal of state-owned assets is subject to complicated approval procedures.
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 38

39. Labor Issues
Settlement of staff and workers may cause substantial costs to the transaction.
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 39

40. Anti-Trust Filing
So far most anti-trust filings have been procedural, but it is expected to have more teeth.
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. 40

41. Intellectual Property Rights
IP protection in China is better than its reputation.
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 41

42. 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 42

43. V. Summary 43

44. Main Points to Note M&A is becoming increasingly popular in China.
“Make it as simple as possible but not any simpler”
- Albert Einstein
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 44

45. Website: www.kingandwood.com
Q&A
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:
Website: 45

46. 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 46

47. Mergers & Acquisitions in China Seminar – February 13, 2008
Felix Chang and Harvey Cohen of Dinsmore & Shohl LLP listen in on the conversation 47