Introduction
Private equity (“PE”) is playing a significant role in the current boom in M&A transactions in China. In 2018, according to statistics from PwC, nearly 2,000 PE deals were announced with a total deal value of approx. US$221.8 billion. In China, from August 1, 2008 [1] , to October 13, 2019, transactions involving PE accounted for around 8.5% of the overall merger filing cases approved by the Chinese authorities the number totaling 239 (including one conditional approval case: Penelope Co., Ltd / Savio Macchine Tessili S.P.A. (2011)).
The merger filing obligation under the Anti-Monopoly Law of China (“AML”) should not be underestimated by PE firms. The parties to the transaction need to avoid unnecessary delay caused by the filing process. Furthermore, the violation of the standstill obligation, or the outright failure to submit a mandatory filing, would result in an administrative punishment by the State Administration for Market Regulation (“SAMR”) in China. Besides, the penalty will be publicized by SAMR and may constitute a violation of law that hinders the process of launching an IPO in China – one of the key ways PE investors seek to get a return on their investment.
This article is intended to give an overview of the merger filing requirements, in particular the procedural and substantive issues specifically related to PE investment. [2]
Merger filing triggers in China
In China, the test to determine whether a filing is necessary consists of two parts: (1) the change of control test; (2) the turnover threshold. In both parts of the test, PE investment has characteristics that would likely trigger merger filing obligations.
Change of control test
Merger filing is only necessary if the transaction leads to a concentration that results in a change of control. “Control” under the AML is slightly different from the notion of control in company law, security law or standard accounting practice in China. The notion of control in the AML encompasses rights, contracts or any other means which, either separately or combined, confer decisive influence on an undertaking. The determination of decisive influence needs a thorough assessment of the transaction agreement, the articles of association and other transaction documents; and needs to look at a series of factors, including the purpose and the business plan of the transaction, the shareholding structure, corporate governance, or other material relations among the parties.
The fact that the shareholding percentage is not the only indicator of control, together with the broader definition of control in China, make it necessary for a PE firm to assess cautiously whether it will acquire control from the AML’s perspective over the target through the proposed transaction. As financial investors, PE firms may only acquire a minority interest, but this does not necessarily mean the PE firm does not have control over the target under the AML. If the PE firm acquires a minority interest that confers veto rights, it is obvious that the PE firm acquires negative control over the target. In some cases where the target has multiple independent rounds of investment, an A-round PE investor may not acquire control in the A-round but may acquire a veto right in the B round under an most favored nation (“MFN”) clause. [3] Then both the A-round PE investor and B-round investor have the legal obligation to make a merger filing before the closing of the B-round.
On the other hand, the acquisition of a majority of the equity by a PE firm does not necessarily result in obtaining sole control over the target. It may also lead to joint control of the target by the PE firm and other shareholders, who could be the founder of the target or other strategic shareholders which have kept a small proportion of equity but have a decisive influence on the target by business arrangements. The determination of sole control or joint control will make a difference regarding which undertakings have filing obligations, and in assessing whether the turnover threshold is reached.
Turnover threshold
The turnover threshold requires that at least two undertakings concerned each generates turnover from China exceeding CNY 400 million and that the total turnover of all the undertakings concerned shall exceed CNY 2 billion generated from China, or CNY 10 billion worldwide. The turnover refers to the revenue in the last fiscal year prior to the date of filing or the date of closing of transaction. Especially for PE firms using bidding consortia, it is critical to bear in mind that if any two parties acquiring the control meet the thresholds mentioned above in China, the merger filing obligation can be triggered even if the target entity does not have any revenue in China.
The calculation of the turnover of one undertaking concerned is not limited to the entity involved in the transaction, but also affiliated entities that control or are controlled by this entity directly or indirectly. In terms of PE investment transactions, the turnover of the PE firm shall include the financial income of the PE firm and the revenue generated by all its controlled portfolio companies, which are deemed to be part of the same group.
A PE firm may set up a series of investment funds as investment vehicles and each of these funds controls a number of portfolio companies. It should be noted that the control over the portfolio companies is actually exercised by the PE firm that sets up the funds, not the fund itself, through the fund’s organizational structure, e.g. by controlling the general partner of the funds and/or by advisory agreements. Therefore, the revenue of all the controlled portfolio companies of the PE firm through different funds shall be taken into the calculation. As a result, large PE firms are frequently required to submit filings in China because they easily exceed the applicable thresholds.
Transactions involving VIE structures
In seeking investment opportunities, overseas PE firms may also confront some companies with red-chip structures [4] and related merger filing issues. For example, during the incorporating and dismantling of the red-chip structure, if there is any change of control over the target due to the entry or exit of the investors [5] , and the turnover threshold is also satisfied, the merger filing obligation is also triggered.
Special attention should be paid to VIE-structure companies [6] , which are quite popular in China as one type of red-chip structure, especially in industries with restrictions on foreign investment, such as internet companies, education, medical services, etc. Generally, the same test for merger filing applies to transactions involving such companies, VIE or not. As long as it constitutes a concentration and the parties reach the turnover threshold, the transaction is required to file in China. However, the validity of VIE structures has been a gray area under Chinese law, that is, neither explicitly permitted nor challenged by any authority. This uncertainty leads to the embarrassing situation that the Chinese authorities (such as MOFCOM and SAMR) are reluctant to review the filing of transactions involving VIE structures.
Another obstacle for the authority to accept filings involving VIE structures is that in the filing form, the filing party shall make a compliance commitment, stating that they do not violate any Chinese law or regulatory regime. However, in terms of VIE structures, the compliance issue cannot be addressed, and the competition authority is not the competent one to solve this problem.
However, following the 2018 institutional reform, it is likely that the new competition authority, SAMR, will accept such merger filing cases and make decisions purely from the perspective of the AML. Previously, the Ministry of Commerce (“MOFCOM”), which was responsible for merger filing reviews, was also in charge of foreign investment approval at the same time. It led to the conflict that MOFCOM’s merger control clearance would be interpreted as a “nod” to the legality of VIE structures as a way of bypassing foreign investment restrictions [7] . After the institutional reform, SAMR as a purely market regulation authority no longer assumes a dual role as its predecessor MOFCOM did.
With the further opening up to foreign investment via the new Foreign Investment Law and the pressure from the public regarding the increasing market concentration in certain industries, it remains to be seen whether the new competition authority SAMR will adopt a pro-active attitude in reviewing merger filing cases involving VIE structures. Therefore, a no filing strategy is probably no longer appropriate for PE firms interested in VIE.
Review procedure and waiting period
Applicability of simplified procedures
The majority of PE deals are financial investments in companies without horizontal business overlaps or vertical relationships with the PE firm’s portfolio. A simplified procedure can be applied in most cases with no or limited horizontal overlap or vertical relations [8] . The reviewing period is up to 30 days [9] (starting from the formal acceptance of the case filing) compared to up to 180 days for a normal procedure, and the materials needed are also less. For example, information on the major suppliers and customers in the relevant market is not necessary for the simplified procedure. However, if the transaction involves sensitive industries, it may face a longer reviewing period. For instance, the reviewing period of Bain Capital/Toshiba Memory Co., Ltd. was around seven months.
Waiting period and gun-jumping violations
After submitting the filing materials, the parties are subject to a standstill obligation. Exercising control over the target before obtaining a formal approval will be viewed by SAMR as a gun-jumping violation. In addition to a fine of up to CNY 500,000, SAMR can also require transaction suspension, divesture and even the restoration of the market situation prior to the transaction [10] . Typical gun-jumping violations include obtaining a business license, the registration of the transferred equity, etc. Therefore, it is critical for PE firms to carefully assess the filing obligations and ensure the clearances are obtained from SAMR prior to the implementation of the transaction.
Substantive assessment: increasing concerns for PE transactions
As for the merger filing process in China, the substantive assessment of transactions involving PE firms is consistent with the standard assessment, including the market definition and the analysis of the potential anti-competitive effects arising from the horizontal overlaps, vertical or complementary relations between the target and the portfolio companies. Where the PE firm controls a large number of portfolio companies active in the same or adjacent sector of the transaction, the data-gathering process may prove very burdensome. In addition, when there are several PE firms involved as co-investors, the assessment shall include the activities and portfolio companies of the other PE firms, which may be extremely time consuming. Therefore, an early self-assessment is recommended.
Typically, PE transactions are unlikely to raise substantive concerns. The large majority of PE transactions have no or limited overlaps with the target’s business. However, with the increasingly large portfolios and intensive industry presence of PE firms, even if the PE firm presents itself as a financial investor without really intervening in the business of the portfolio companies, competition concerns may also arise due to the large market share of the portfolio companies. In that case, SAMR may grant a conditional approval or even make a prohibition decision.
The conditions could be behavioral, structural, or a combination of the two. For instance, in the case of Penelope Co., Ltd / Savio Macchine Tessili S.P.A., Alpha Private Equity, the actual controller of the acquiring party, was required to sell the equity of another portfolio company, which was the only competitor of the target in the relevant market. For the cases with competition concerns, the filing parties are recommended to proactively talk to SAMR and submit timely remedy proposals to SAMR to address the competition concerns. If the filing parties fail to agree on the final remedy with SAMR before the end of the 180-day statutory review period, a prohibition decision may be imposed. That said, a number of cases with competition concerns have been withdrawn and refiled to circumvent such a time limit. In order to avoid unexpected outcomes, a remedy discussion with the SAMR at an early stage of the merger filing process is encouraged.
To conclude, PE firms need to pay close attention to merger control issues in China, from the perspectives of both filing requirements and substantive analysis, to avoid unexpected outcomes or undue delays of transactions due to the waiting period. The proposed amendment to the AML, drafted by SAMR and publicized in early January 2020, signals a hugely increased penalty for gun-jumping (the fine ceiling will rise from CNY 500,000 to 1% of the previous year’s turnover). This change just around the corner is another reason why understanding the rules and practice of merger control in China is so important and pressing for PE firms.
References
[1] The effective date of the Anti-Monopoly Law of the People’s Republic of China.
[2] In some cases, China Securities Regulatory Commission (“CSRC”) will require a statement from external legal counsel or brokers that the failure to file the transaction is not a kind of serious illegal activity, and it may even require a statement from the competition authority.
[3] The A-round investors will have the same rights as investors that entered in the later rounds of investment.
[4] A red chip is a company incorporated outside mainland China and traded on stock exchange(s) outside mainland China, but is substantially owned, directly or indirectly, by mainland China entities with the majority of its revenue or assets derived from mainland China.
[5] E.g. PE funds.
[6] In China, typically a VIE (variable interest entity) structure refers to a structure whereby an entity established in China that is fully or partially foreign owned has control through contracts over an operating company which holds the necessary license(s) to operate in a FDI (foreign direct investment) restricted/prohibited sector.
[7] E.g. Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors (Regulation 10); Special Administrative Measures (Negative List) for Foreign Investment Access, etc.
[8] The eligibility for the simplified procedure relies on an assessment of the specific transaction and its relevant market share. The market share refers to the market share held by all the portfolio companies controlled by the PE firms in the relevant markets.
[9] The reviewing period of the simplified procedure includes a pre-clearance disclosure process, lasting for 10 calendar days from the date of formal acceptance of the case filing.
[10] So far the most common penalty is an administrative fine, due to the lack of an anti-competitive effect, and the competition authority has not required the restoration of the pre-merger market situation in gun-jumping cases.
