A Series of Recent Regulations Pose New Challenges for China’s Private Equity and Venture Capital Industry
Less than a year after the State Administration of Foreign Exchange ("SAFE") Circular No. 75, heralded the resumption of private
equity and venture capital ("PE/VC") investments which had stalled under SAFE Circulars No. 11 and 29[fn1], the PE/VC industry in China again faces challenges resulting from a several new regulations imposing new foreign investment
restrictions in China. On July 13, 2006, the Ministry of Information Industry ("MII") imposed new requirements on foreign-invested value-added telecom
("VAT") businesses (which cover internet and wireless content-related services) ("Notice Regarding Strengthening Administration of Foreign Investment in Operation of Value-Added Telecom Business" or the "MII Notice"). Less than a month later, the Ministry of Commerce ("MOFCOM"), joined by the State-owned Assets Supervision
and Administration Commission of the State Council, China Securities Regulatory Commission ("CSRC"), and SAFE amended and
released the Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises ("Amended M&A Rules").
The New M&A Rules
The Amended M&A Rules, which take effect on September 8, 2006, impose new restrictions on offshore-onshore restructurings, a tool to establish an offshore special purpose
vehicle ("SPV") which serves as the entity for PE/VC investments, mergers and acquisitions, and initial public offerings in
China-based companies. Highlights of the Amended M&A Rules which affect PE/VC transactions include the following:
- MOFCOM approval is required by PRC individuals and companies establishing an SPV;
- MOFCOM approval must be obtained when an SPV or its shareholders engage in a share-for-share exchange to acquire a domestic
company (a "Share Swap");
- An overseas IPO of an SPV must be approved by the CSRC and is subject to MOFCOM reporting;
- The MOFCOM Share Swap approval will become invalid if the SPV does not complete an overseas IPO within one year from the issuance
of the business license to the SPV; and
- Acquisitions of domestic targets engaged in key industrial sectors which affect (or may affect) the security of the "national
economy", or which own well-known trademarks or traditional brands in China, will be subject to heightened scrutiny, as MOFCOM
will have the right to review, approve and void such acquisitions for anti-trust and related concerns.
New Regulations on Internet and Wireless Content Companies
In addition to the Amended M&A Rules, the MII Notice places new restrictions on internet and wireless content providers in
China, which represent a significant segment of the China-related companies that have obtained PE/VC financing in recent years,
and an overwhelming majority of those which have been the subject of high-profile mergers and acquisitions and NASDAQ initial
public offerings.
Given the restrictions on direct foreign ownership of VAT enterprises, the SPVs in these industries have for years used contractual
mechanisms to conduct business through domestically-owned PRC affiliates (each, a "Restricted Company") that hold value-added
telecommunications ("VAT") licenses. Under these arrangements, the SPV and/or its wholly owned PRC subsidiary (a wholly-foreign
owned enterprise, or "WFOE") license intellectual property (such as trade marks and domain names) and provide consulting services
and other resources to the Restricted Company, in return for significant license and service fees representing a significant
percentage of the Restricted Company’s revenues.
The new MII Rules, which include new requirements and punitive measures for non-compliance, suggest that the structure of
existing SPVs to control and operate Restricted Companies may need to be adjusted:
- Foreign investors in VAT enterprises are prohibited from operating such enterprises without a VAT license;
- Existing VAT enterprises (many of which are currently listed on Nasdaq) must engage in "self-examination" and report the results
of such examination to the appropriate provincial and municipal counterparts of MII by November 1, 2006;
- VAT enterprises must not in any form covertly lease, transfer or sell, VAT license to a foreign investor, or covertly provide
resources, premises of facilities to a foreign investor for the purpose of illegally operating a VAT business in China;
- Restricted Companies that hold VAT licenses (or their domestic shareholders) must own the related domain names and trademark
of the business; and
- VAT enterprises seeking to list on an overseas exchange must obtain pre-approval from MII.
Since the MII Notice requires that the Restricted Company own the intellectual property and have sufficient employees and
other resources to support its profit-making activities, the challenge that investors, counsel, accountants will have is to
determine whether the SPV (through its WFOE) owns and is able to provide the Restricted Company with sufficient assets, employees
and services to justify the service fees it earns from the Restricted Company.
Conclusion
The recent new regulations are a continuation of a process of government agencies working to more actively regulate business
activities that have fallen between the cracks of their existing regulatory reach. Like the SAFE Circulars, we would expect
a period of time during which the market response to the regulations will be gauged and contours of how the regulators will
act should become clearer. It does appear clear that MOFCOM, CSRC and MII intend to more actively regulate the listing of
such enterprises on overseas exchanges. It is also clear that while both the Amended M&A Rules and MII Notice will be subject to significant administrative interpretation, these notices are intended to increase PRC government oversight over PE/VC financings and liquidity events in China.
Footnote
1 Additional information about these circulars can be found at: http://www.mofo.com/news/updates/files/update02094.html
