This article is an extract from TLR The Private Equity Review – Edition 12. Click here for the full guide
The year 2022 witnessed a sharp decrease in both volume and value of private equity investments in China due to the disruptions, challenges and uncertainties in the domestic pandemic situation as well as the international environment (e.g., the Russia–Ukraine war, supply chain disruptions, tightening regulatory scrutiny and high inflation). Specifically, in 2022, there were 2,044 private equity investments (of which 889 were publicly disclosed) for an aggregate investment amount of approximately US$61.69 billion, according to AVCJ Research,2 the market research division of Asian Venture Capital Journal, representing a 29.9 per cent decrease in total investment volume and 52.3 per cent decrease in total value compared with the 2,916 investments for an aggregate investment amount of approximately US$129.45 billion in 2021. China remained an active private equity market in Asia and contributed approximately 27.5 per cent of the total value of private equity investments in the Asia-Pacific region in 2022.
Investments declined across financing stages in 2022. According to AVCJ Research, investments in buyout transactions (including management buyout, management buy-in, leverage buyout, and turnaround or restructuring stages) dropped from US$11.387 billion or 8.8 per cent of total investment value in 2021 to US$5.026 billion or 8.1 per cent of total investment value in 2022. Although staying ahead of other investment stages in terms of the proportion (representing 59.3 per cent of total investment value in 2021 and 70.3 per cent of total investment value in 2022), the total value of investments at expansion and growth stages notably decreased from US$76.824 billion or 59.3 per cent of total investment value in 2021 to US$43.386 billion or 70.3 per cent of total investment value in 2022. Investments in private investment in public equity financing significantly dropped from US$6.274 billion or 4.8 per cent of total investment value in 2021 to US$0.049 billion or 0.1 per cent of total investment value in 2022. Investments in mezzanine and pre-initial public offering (IPO) stages drastically decreased from US$12.628 billion or 9.8 per cent of total investment value in 2021 to US$1.804 billion or 2.9 per cent of total investment value in 2022. Investments at the start-up and early stages slightly decreased from US$1.199 billion in 2021 to US$1.026 billion in 2022, while constituting a bigger proportion of total investment value in 2022 than in 2021, expanding from 9.3 per cent of total investment value in 2021 to 16.6 per cent of total investment value in 2022.
After a strong bump up in 2020 and a decline in 2021, China-based private equity buyouts continued their decrease in 2022. In general, buyout investments in China have remained less frequent in comparison with many other jurisdictions. Buyout activities experienced an increase in 2010 and 2011, further strengthened in 2012 to 2014 amid the growing popularity of going-private transactions involving China-based companies, particularly companies listed in the United States and boomed to be the bandwagon in 2015 as many US-listed Chinese companies received going-private proposals at the prospect of seeking a future listing on China’s A-share market or the Hong Kong Stock Exchange (HKEX). After experiencing a decline in 2016 and a short recovery in 2017, buyout activities in China hit a record low in 2018 and further dropped to the lowest point in history in 2019, and going-private activities were almost suspended. Both buyouts and going-private activities experienced a strong rebound in 2020, which was not carried on into 2021 or 2022. Based on statistics obtained through searches on the Thomson Reuters database Thomson ONE, of the 276 going-private transactions announced since 2010, 52 did not proceed and 197 have closed (12 closed in 2010, 16 closed in 2011, 25 closed in 2012, 26 closed in 2013, six closed in 2014, 28 closed in 2015, 19 closed in 2016, eight closed in 2017, three closed in 2018, 12 closed in 2019, 24 closed in 2020, 11 closed in 2021 and seven closed in 2022). As at 31 December 2022, 21 going-private transactions were pending, including one announced in 2012, two announced in 2015, one announced in 2016, one announced in 2017, four announced in 2020, three announced in 2021 and seven announced in 2022.
Exit transactions face a significant slowdown in China, with the exit value of private equity-backed exits decreasing from US$20.715 billion in 2021 to US$3.921 billion in 2022, led by a slowdown in IPOs following market corrections in 2022. Nevertheless, private equity-backed IPOs are still an exit route heavily relied on by China-focused private equity funds, with US$53.526 billion funds raised in 2022, which represents a decline from US$61.016 billion in 2021 but an increase compared with US$46.388 billion in 2020 and US$16.542 billion in 2019. Retrospectively speaking, Chinese A-share IPOs experienced a dramatic decline in 2018 on account of a backlog of IPO applications caused by tightening review standards. In 2019, China inaugurated its science and technology innovation board (the STAR Market), trying to kick off the country’s much-anticipated capital market reform and implement a registration-based IPO regime to address investors’ concern about the backlog. In the wake of the launch of the new regime, 202 Chinese enterprises accomplished A-share IPOs successfully in 2019 (including 70 companies that were successfully listed on the STAR Market). Following this trend, the number of private equity-backed IPOs reached 199 in 2020, which is effectively double the number in 2019. Due to the continued promotion of the registration-based IPO regime, the number of Chinese enterprises that accomplished A-share IPOs in 2021 reached 522, with 399 being listed under the new registration-based regime. In 2022, the number of Chinese enterprises that accomplished A-share IPOs decreased to 424, representing an 18.77 per cent decline. The reform of the listing system in China boosted the confidence of the private equity investors in the domestic market in China, and 354 of 424 Chinese enterprises are listed under the new registration-based regime in 2022, representing 83.49 per cent of the total A-share IPOs.
On the other hand, exit via secondary sales, accounting for 68.8 per cent of private equity-backed exits in 2022 (in terms of deal value),3 became the dominant exit route for private equity funds in 2022. Trade sales used to be the dominant exit route for 2019, 2020 and 2021, representing 90.1 per cent, 93.2 per cent and 77.9 per cent of total private equity-backed exits value in each year, respectively. Secondary sales are thriving year by year, with the proportion of the total private equity-backed exits value remarkably growing from 16.4 per cent in 2021 to 68.8 per cent in 2022, replacing trade sales as the dominant exit route in 2022. Though trade sales came second in terms of the total deal value of private equity-backed exits, they remain the predominant approach for private equity-backed exits in 2022, as 21 out of 35 deals are trade sales.
The value of announced Chinese outbound M&A deal activity for the first three quarters of 2022 was down 49 per cent year on year to a historic low compared with the same period in past years. The number of announced Chinese outbound M&A deals decreased 6 per cent compared with the same period in 2021. Such a fall may result from a slowing global economy. On the other hand, state-owned enterprise (SOE)-backed Chinese outbound investments (which were historically the mainstream of outbound investments in 2016) continued to steer their attention back to the domestic market and the Asia market, partly due to geopolitical tensions and the unfavourable regulatory environment in the United States and some European countries.
II Legal framework
i Investments through acquisition of control and minority interests
An enterprise established under Chinese laws and wholly or partly owned by a foreign investor (in a Chinese foreign investment law context, investors from Hong Kong Special Administrative Region, Macau Special Administrative Region and Taiwan are deemed as special foreign investors) is called a foreign-invested enterprise (FIE). An FIE can take several forms, including joint ventures, wholly owned foreign enterprises, foreign-invested companies limited by shares and foreign-invested partnerships. The governance framework of these legal entities is set out in the current Company Law (see latest development of the Company Law in Section IV.iv), which became effective on 1 January 2006 and was amended in 2013 and 2018 with effect from 26 October 2018; the Partnership Enterprise Law, which was first adopted on 23 February 1997 and was amended in 2006 with effect from 1 June 2007; the Foreign Investment Law (the FIL), which was promulgated on 15 March 2019 and became effective on 1 January 2020; and the Regulation on the Implementation of the Foreign Investment Law (the FIL Implementation Regulation), which was promulgated on 26 December 2019 and became effective on 1 January 2020.
Prior to the promulgation and implementation of the FIL, foreign investors who had been operating in China for decades faced certain hurdles in respect of business establishment and investment treatment and were prevented from making investments in certain sectors unless they teamed up with a Chinese partner. The FIL and its subordinate regulations are intended to address these issues. Under the new legal regime, foreign investments will receive national treatment (i.e., foreign investors will be treated in a way that is no worse than that accorded to Chinese domestic investors) and a negative list management system (i.e., other than the specific industries or sectors as set forth on the Special Administrative Measures (Negative List) for the Access of Foreign Investment (the Foreign Investment Negative List), in which foreign investments are prohibited or restricted (i.e., subject to certain entry conditions), all other industries or sectors are open to foreign investment without any limitation). The FIL and the FIL Implementation Regulation have emphasised the protection and promotion of the investments by and the rights and interests (including intellectual property rights) of foreign investors in China. The relevant regulation has reaffirmed that all the national policies relating to supporting the development of enterprises shall apply equally to FIEs. FIEs are also guaranteed equal opportunities to participate in the formulation of industry standards and government procurement activities through fair competition. Another significant change under the new regime is that FIEs’ structures, governance and voting procedures are made fully compatible with those of domestic enterprises and are subject to the Company Law, thus providing more operational flexibility. Notably, FIEs formed under the Law on Wholly Foreign-Owned Enterprises (for wholly foreign-owned enterprises (WFOEs)), the Law on Sino-Foreign Equity Joint Ventures and the Law on Sino-Foreign Cooperative Joint Ventures (collectively, the Old FIE Laws, which have been replaced by the FIL) with certain corporate governance rules that were different from those required under the Company Law are granted a five-year grace period until 1 January 2025 to convert their governance structures and amend their charter documents to comply with the requirements under the FIL and the Company Law. If such FIEs fail to make the changes within the grace period, the registration authority will no longer process their application for registration or filing matters.
A new information reporting system has also replaced the historical approval and record filing regulatory system for the establishment and changes in respect of FIEs. Prior to the implementation of the FIL and the FIL Implementation Regulation, FIEs needed to conduct record filing for information on the enterprise, foreign investment and general mergers and acquisitions made by foreign investors and make changes to such information through two channels: (1) the Ministry of Commerce (MOFCOM) foreign investment record filing system; and (2) the company registration system and enterprise credit information disclosure database of the State Administration of Market Regulation (SAMR) (the enterprise registry agency that records all enterprise registration information of legal entities incorporated under Chinese laws, whether domestic companies or FIEs). With the implementation of the FIL and the Foreign Investor Information Reporting Measures (the Reporting Measures), which were issued by MOFCOM and SAMR on 30 December 2019 and took effect on 1 January 2020, MOFCOM’s record filing system has been replaced by a unified information reporting system for the establishment of FIEs and their subsidiaries, making changes to FIEs and their subsidiaries, and submission of annual reporting. In practice, this information reporting system is integrated as part of the regular online registration procedure with SAMR. Information already submitted to SAMR by FIEs will be shared with MOFCOM and does not need to be submitted again separately by FIEs or foreign investors through information reports.
Foreign investment in the form of acquisition of equity or assets of Chinese companies by foreign investors under the new information reporting system is no longer subject to regulatory approvals (as required by the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, jointly issued by six governmental agencies in 2006 and amended in 2009), provided that the transaction does not trigger ‘special management measures for foreign investment access’ under the Foreign Investment Negative List (see further discussion below).
Regulatory regimes applicable to foreign investments
Investment access of foreign investors in China is subject to the negative list management. The Foreign Investment Negative List, jointly published annually by MOFCOM and the National Development and Reform Commission (NDRC) (with the latest edition effective from 1 January 2022, see further discussion on the amendments to the 2021 edition in Section IV.iii), sets forth the industries and sectors to which special management measures for foreign investment access are applicable. The Foreign Investment Negative List specifies only two categories: industries or sectors in which foreign investment is prohibited; and industries or sectors in which foreign investment is allowed with certain investment restrictions. Industries or sectors not mentioned by the Foreign Investment Negative List are deemed ‘permitted’ (i.e., not subject to the special management measures for foreign investment access). On 26 October 2022, NDRC and MOFCOM promulgated the Catalogue of Encouraged Industries for Foreign Investment (2022) (the Catalogue of Encouraged Industries), which became effective on 1 January 2023. The Catalogue of Encouraged Industries consists of two sub-catalogues (the list applicable to the entire country and the list applicable to China’s central, western and north-eastern regions and Hainan province only). While a foreign investor can acquire full ownership of a company in most encouraged and permitted industries or sectors (and is often entitled to special advantages compared with domestic investors when acquiring any or all interests in a company that falls into an encouraged industry or sector), to invest in most industries or sectors subject to the special management measures for foreign investment access (i.e., restricted industries or sectors), a foreign investor is required to team up with a Chinese partner (and, in some cases, the Chinese partner must maintain a controlling stake). Investments by a foreign party in a prohibited industry or sector are not legally allowed; investments by a foreign party in a non-prohibited industry or sector stipulated in the Foreign Investment Negative List will require the applicable project-based approval of the central NDRC if the size of a greenfield investment or the total investment amount in a target enterprise (including capital increase) is US$300 million or more, or require the approval of NDRC’s local counterpart if the size of a greenfield investment or the total investment amount in a target enterprise (including capital increase) is below US$300 million. Approval at the local-level NDRC can typically be obtained within one month, but approval from the central NDRC often takes several months or longer. If a transaction is subject to an antitrust or national security review, as discussed below, NDRC or its local counterpart will typically defer review until the antitrust or national security reviews are completed. Apart from these general approval requirements, foreign investments in several industries, such as telecommunications, are subject to approval from the relevant Chinese regulatory authorities governing the applicable industries. An indirect investment in China by way of an offshore investment in an offshore holding company that owns equity of an FIE is not subject to MOFCOM or NDRC approval applicable to an onshore investment; however, both the onshore and the offshore investments may be subject to China’s antitrust and national security review schemes.
The antitrust regime in China primarily consists of the Anti-Monopoly Law of the People’s Republic of China (PRC) (the AML), which became effective on 1 August 2008 and was revised in 2022 with effect from 1 August 2022. Changes introduced by the amended AML in 2022 include a new merger control threshold and a significant increase in fines (see further discussion in Section II.iii). Pursuant to the AML, an antitrust filing with the SAMR anti-monopoly authority is required for any transaction involving a change of control if the individual Chinese turnover of at least two operators exceeds 800 million yuan in the preceding financial year and the combined turnover of all operators exceeds 12 billion yuan on a global basis or 4 billion yuan within China. If the turnover threshold is not met, the transaction might still be notifiable to SAMR if the Chinese turnover of one business operator involved in the concentration exceeds 100 billion yuan in the past financial year and the market value or valuation of the other party(ies) to the merger or other business operator(s) is no less than 800 million yuan and its (their) turnover within China in the preceding financial year accounts for more than one-third of its (their) global turnover in the same year. Also, SAMR is empowered to review ‘below threshold’ transactions if it believes that the proposed transaction may raise competition concerns.
The regime of Chinese national security review of foreign investment was introduced in 2011 by the Notice of the General Office of State Council on Establishment of Security Review System Pertaining to Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (Circular 6), which outlines the principles, scope and procedures of security review. On 25 August 2011, MOFCOM issued the Provisions on Implementation of Security Review System for Mergers and Acquisition of Domestic Enterprises by Foreign Investors, providing further guidance on the national security review. The General Office of the State Council later issued the Tentative Measures for the National Security Review of Foreign Investment in Pilot Free Trade Zones, which took effect in May 2015 (the Tentative Measures), extending the application of national security review to important culture and information technology products or sectors that are vital to national security and where foreign investors have de facto control over the invested entities. The types of foreign investments regulated by these Tentative Measures include sole proprietorship, joint venture, equity or asset acquisition, control by contractual arrangements, nominal holding of interests, trusts, re-investment, offshore transactions, leaseholds and subscription of convertible bonds. To further implement requirements under the FIL regarding national security review of foreign investment, on 19 December 2020, NDRC and MOFCOM jointly issued the Measures on Security Review of Foreign Investment (the FISR Measures), which took effect on 18 January 2021. The FISR Measures amend the previous review framework stipulated by the Tentative Measures and provide detailed rules to tackle the rising national security concerns and to address the global trend of strengthening national security review on foreign investment. NDRC will establish a working office (the Security Review Office) led by NDRC and MOFCOM to conduct routine security review and coordinate with other governmental authorities involved in the security review process. Sectors listed under the FISR Measures that are subject to security review are divided into two categories: (1) foreign investment in military, military support and other areas related to national defence and security, as well as investments in the proximity to military and military-related industrial facilities; and (2) foreign investment in important agricultural products, energy and resources, manufacturing, infrastructure, transportation services, cultural products and services, information technology and internet products and services, financial services, key technologies and other important areas that are relevant to national security, through which the foreign investors obtain actual control of the invested enterprises. While the term ‘control’ is clearly defined in the FISR Measures as ‘holding 50 per cent or more of the equity of an enterprise; holding voting rights that can have significant impact on the resolutions of the board of directors, the board of shareholders or the shareholders’ meeting or other circumstances that create significant impact on the enterprise’s business decision-making’, the FISR Measures do not specifically define ‘important’ and attach a broad meaning to ‘national security’, leaving wide discretion to the review authority. As such, private equity investments involving certain customary protections (e.g., veto rights, supermajority voting requirements and negative covenants) could arguably be interpreted to confer control under the FISR Measures. In the event of any ambiguity as to whether a filing is required, it is usually prudent for an investor to make a filing to avoid adverse consequences later.
Governance of and exit from Sino-foreign joint ventures
Since the FIL became effective, all FIEs are regulated pursuant to the Company Law, the FIL and the FIL Implementation Regulation, doing away with some onerous requirements on corporate governance of FIEs (e.g., for Sino-foreign equity joint ventures, certain key corporate actions required unanimous approval by the board, which, coupled with the Chinese partner’s typical right to appoint at least one director, essentially gave the Chinese partner certain veto rights regardless of its shareholding percentage). Such changes to the regulatory framework enable foreign shareholders in an FIE to more easily obtain or enforce certain contractual rights that are considered fundamental for private equity investors in other jurisdictions, including rights pertaining to governance and exit.
If the Chinese shareholder is an SOE, enforcement of certain contractual rights against it may be challenging, as the transfer of an SOE’s interest in a joint venture is subject to a statutory appraisal and an open bidding procedure, unless waived by the appropriate authorities. Regardless of what rights may be agreed in a joint venture contract, it may be a long shot for a local Chinese court to grant specific performance against a Chinese shareholder in favour of a foreign investor.
Implications of the regulatory framework on a transaction structure
To avoid going through the formalities with NDRC, SAMR and MOFCOM (for any approval or information reporting) and to enhance structuring flexibility, foreign private equity investors typically prefer to invest in China through an offshore structure. The ideal transaction structure, when feasible, is that the foreign investor invests alongside a Chinese partner in an offshore Cayman Islands or British Virgin Islands company owning 100 per cent of a Chinese WFOE (often indirectly through a Hong Kong entity, to obtain preferential tax treatment on dividends). This structure also allows the foreign investor to benefit from transaction agreements governed by foreign laws and to avoid the need to enforce its rights under Chinese law.
Many foreign investors use a variable interest entity (VIE) structure to invest (indirectly) in China to avoid seeking certain Chinese regulatory approvals on the business of Chinese enterprises (approvals that will not be granted or are not expected to be granted to FIEs). Under a VIE structure, Chinese individuals, often the founders, key management members or their relatives, are the registered shareholders of a domestic operating company that holds the required licences and permits needed for the business to operate. A foreign investment entity (often in conjunction with the founders) then forms a WFOE through an offshore entity it owns, and the WFOE enters into a series of contractual arrangements with the domestic operating company and its registered shareholders pursuant to which the WFOE obtains control over and full economic interest in the operating company whose financial statements will be consolidated by the WFOE and its group companies. These contractual arrangements can take many forms, but often include an exclusive service or licence agreement, a voting proxy agreement, a share pledge agreement and a loan agreement, and an exclusive option agreement (together with a form of equity transfer agreement) allowing the WFOE (when permitted by Chinese law) or its appropriate affiliates or designees to acquire the equity interests or assets of the operating company. Commentators frequently note that the VIE structure is legally risky given that it arguably violates the spirit (if not the explicit text) of Chinese regulations; however, Chinese companies, including some of the largest public companies, such as Alibaba, Baidu and Tencent, continue to use this structure.
The FIL and the FIL Implementation Regulation remain silent on the topic of VIEs. It is understandable that, given how widespread the practice is (i.e., a large number of enterprises are currently organised using the VIE structure), the potential impact of changing the status quo may be significant and unpredictable. Notably, the FIL provides that foreign investment includes acquisition by a foreign investor of shares, equities, property shares or any other ‘similar rights and interests’ of an enterprise within the territory of China. ‘Similar rights’ is a term broad enough to include interests derived from a VIE structure. Such phrases in FIL not only afford companies enough room to structure their form with VIE but also give the government ground to assert jurisdiction over the VIE structure when the time is right. In a Q&A with the China Securities Regulatory Commission (CSRC) officials on recent overseas listing development in 2022 (see further discussion in Section IV.ii), it was specifically pointed out that domestic enterprises with a VIE structure may conduct overseas issuance and listing of securities as long as they are compliant with applicable laws, regulations and regulatory filing requirements on foreign investment, industry access, cybersecurity, data security and others.
ii Fiduciary duties and liabilities
Fiduciary duties and potential liabilities of directors, officers and supervisors under Chinese law
The Company Law is the primary statute regulating the actions and duties of directors, officers and supervisors of a Chinese company. Pursuant to the Company Law, a director, officer or supervisor must abide by the laws, administrative regulations and articles of association of the company, and has duties of loyalty and care to the company. Similar to many other countries, a breach of duty by a director, officer or supervisor of a Chinese company may give rise to civil, administrative or criminal liability. A particular concern to a private equity investor in China, however, is that a director, officer or supervisor may be liable for criminal liability not only for his or her own wrongdoing but also for crimes committed by the company if he or she is the ‘manager directly in charge’ or ‘person directly responsible’ for the management of the matter with respect to which a specific criminal act was committed by the company. This risk of personal liability for company wrongdoing is more acute for a director or officer who is also the chair of the board, executive director or legal representative of the company or who otherwise serves in a senior management capacity, such as a general manager or chief financial officer. Under the Securities Law, which was promulgated on 28 December 2019 and took effect on 3 March 2020, directors, supervisors and senior officers of a public company in China shall bear compensation liability jointly and severally with the company for damages suffered by investors due to any false records, misrepresentation or material omission in the information disclosure made by the company unless they can prove that they are not at fault. Often by way of seeking to ensure that their representatives are not assigned responsibility for any specific matters, most non-Chinese private equity funds are comfortable appointing their representatives to the boards of Chinese companies, despite the risk of liability. While directors’ and officers’ insurance and indemnification agreements may protect against civil liability, many types of administrative and criminal liability cannot be mitigated by insurance and indemnification.
Chinese tax exposure
Since January 2008, China’s Enterprise Income Tax Law (the EIT Law) has imposed a 10 per cent capital gains tax on the sale of a domestic Chinese company by a foreign investor. On 3 February 2015, the State Administration of Taxation of the PRC issued Circular (2015) No. 7 (Circular 7) on Chinese corporate income tax treatments of indirect transfers of Chinese assets (including equity interest in a Chinese company) by non-resident enterprises. Under Circular 7, an indirect equity transfer of a Chinese entity by an offshore seller (such as selling the equity of an offshore holding company) that does not have a reasonable commercial purpose and that is structured to avoid applicable Chinese taxes will be re-characterised by the Chinese tax authorities as a direct equity transfer of the Chinese entity for Chinese tax purposes, and the offshore seller will be required to pay capital gains tax for the transaction. Although it is within the discretion of the parties to such offshore transactions to determine whether to make a Circular 7 filing to report the offshore transaction for the Chinese tax authorities’ assessment for Chinese tax purposes, Circular 7 employs a penalty structure designed to motivate parties to offshore transactions involving indirect sales of Chinese companies to report potentially taxable transactions to the Chinese tax authorities. Because of the uncertainty under the Circular 7 regime regarding what will satisfy the Chinese tax authorities as a non-tax avoidance justification with reasonable commercial purpose for the offshore sale of Chinese entities, and regarding the evolving market practice with respect to these matters, many practitioners interpret the application of Circular 7 in a broad way and recommend making Circular 7 filings to reduce the risks and potential penalties for evading Chinese tax obligations.
An offshore vehicle established by a non-Chinese private equity investor to make an investment in a Chinese company will be treated as a PRC-resident enterprise under the EIT Law and will be subject to a flat 25 per cent enterprise income tax on its worldwide income if the offshore vehicle’s de facto management body is in China. Although the language of the law is unclear, factors that the State Administration of Taxation may take into account in determining tax residency include whether the offshore vehicle locates its senior management and core management departments in charge of daily operations in China; whether the financial and human resources decisions of the offshore vehicle are subject to determination or approval by individuals or bodies in China; whether the offshore vehicle’s major assets, accounting books, company seals, and minutes and files of board and shareholders’ meetings are kept or located in China; and whether at least half of the offshore vehicle’s directors or senior management reside in China. To mitigate the risk that any dividends, sale proceeds or other income received by an offshore vehicle might be subject to this tax, an offshore vehicle should take steps to establish that it is not effectively managed and controlled in China.
iii Governmental enforcement actions
Update on Foreign Corrupt Practices Act enforcement and developments
The US Department of Justice (DOJ) and the US Securities and Exchange Commission (SEC) restored aggressive Foreign Corrupt Practices Act (FCPA) enforcement in 2022. In total, the DOJ and the SEC imposed approximately US$1.7 billion in penalties and fines in 2022, a substantial increase from US$465 million in 2021. Although there was only one FCPA enforcement action involving China in 2022, this slowdown was likely due to China’s pandemic situation, which made China-based enforcement actions and investigations particularly challenging. Given that China has scrapped most of its stringent pandemic control measures, it is likely that more FCPA enforcement involving China will ensue in the forthcoming year.
In 2022 and early 2023, the Biden administration announced several key updates on the FCPA enforcement trend. The most high-profile development was that, on 15 September 2022, the DOJ Deputy Attorney General, Lisa Monaco, announced key policy changes to corporate crime prosecution (the Monaco Memo).
- Individual accountability remains the DOJ’s top priority. Companies must produce all relevant, non-privileged facts and evidence about individual misconduct on a timely basis to obtain full cooperation credit.
- Voluntary and timely self-disclosure is emphasised as the clearest path for a company to avoid a guilty plea or indictment and monitorship, absent aggravating circumstances such as executive misconduct or criminal recidivism.
- The quality of a company’s compliance programmes can be viewed through two additional factors: (1) whether it has structured its compensation to provide financial penalties (e.g., clawbacks for misconduct) and incentives (compensation for pro-compliance conduct); and (2) whether it has implemented effective policies and procedures governing the use of personal devices and third-party messaging platforms to ensure that business-related communications are preserved. Evaluation of the compliance programme can affect the terms of resolution, including the imposition of a compliance monitor.
- Companies seeking cooperation credits must also preserve, collect and disclose in a timely manner relevant documents located outside the United States to US regulators and, if difficult, prove the restraints in foreign data privacy laws and blocking statutes, etc., and demonstrate alternative solutions. Using a foreign law (such as China’s restrictions on cross-border data transfers) to avoid producing documents in the United States might be viewed as a negative inference by US authorities.
Further, the SEC strengthened its whistle-blower programme by providing stronger incentives. On 26 August 2022, the SEC amended Rule 21F-3 and Rule 21F-6 under Section 21F of the Securities Exchange Act of 1934, entitled ‘Securities Whistleblower Incentives and Protection’. The amended rules allow the SEC to pay whistle-blowers for their information and assistance in connection with non-SEC actions under certain circumstances and confirm the SEC’s authority to potentially increase the amount of an award, but not lower it. In 2022, the SEC awarded approximately US$229 million in 103 awards, making 2022 the SEC’s second-highest year in terms of dollar amounts and number of awards. The strengthened whistle-blower programme has a growing international impact. Since the beginning of the whistle-blower programme, the SEC has received whistle-blower tips from individuals in approximately 133 countries outside the United States. According to the annual report for financial year 2022 issued by Office of the Whistleblower of SEC on 15 November 2022, tips were received ‘from all over the world’, with the highest number of foreign tips originating from countries including China.
The US Public Company Accounting Oversight Board reached agreement with Chinese authorities on audit inspections and investigations
In August 2022, the US Public Company Accounting Oversight Board (PCAOB) signed a Statement of Protocol (SOP) with CSRC and China’s Ministry of Finance (MOF) regarding inspections of PCAOB-registered audit firms based in China and Hong Kong. This is a landmark development since the US Congress enacted the Holding Foreign Companies Accountable Act (HFCAA) in 2022, which requires the SEC to identify any public companies that the PCAOB has determined it is unable to inspect or investigate completely because of positions taken by a foreign authority, and prohibits in the United States the trading of securities of companies that have been so identified for three consecutive years. In December 2021, the PCAOB determined that Chinese authorities prevented it from inspecting and investigating companies based in mainland China and Hong Kong completely. To address this situation, the SOP signed in 2022 created a framework for Chinese companies to avoid being so identified and remain listed in the United States.
The SOP outlined four main commitments required by the PCAOB from Chinese authorities. First, the PCAOB has sole discretion to select the audit firms and US-listed Chinese companies for examination. Second, the PCAOB can interview and obtain testimony from any personnel of audit firms in China and Hong Kong. Third, the PCAOB inspectors can access all audit workpapers without any redaction, except for a limited set of ‘restricted data’ (including personally identifiable information), which PCAOB inspectors and investigators can view only in camera. The PCAOB can retain reviewed information, including restricted data, as needed to support its inspection and investigation findings. Finally, the PCAOB can transfer identified information, including restricted data, to the SEC, and the SEC can use the information for all SEC purposes, including administrative or civil enforcement actions. This theoretically includes enforcement actions against the US-listed companies audited by the inspected auditor.
Following the SOP, PCAOB sent 32 staff to Hong Kong to conduct nine weeks of on-site inspections and investigations over two auditors (KPMG in mainland China and PwC in Hong Kong) and eight of their engagements. In December 2022, the PCAOB announced that it was able to secure, for the first time, complete access to inspect PCAOB-registered public accounting firms in mainland China and Hong Kong at its sole discretion, thus resetting the three-year non-compliance period for Chinese companies subject to the HFCAA. According to SEC Chair Gary Gensler, Chinese authorities had complied with the commitments in the SOP, but the PCAOB identified numerous potential deficiencies in the work of the two audit firms. The PCAOB is to release inspection findings in the first half of 2023 and continue its inspections and investigations in 2023.
Chinese anti-corruption enforcement
In 2022, anti-corruption legislation and enforcement remained a top priority for Chinese authorities, unveiling new challenges for private equity firms conducting business in China.
First, China has continued to clamp down on bribe-givers. In March 2022, the National Supervisory Commission and the Supreme People’s Procuratorate (SPP) issued the Notice of Representative Cases Involving Crimes of Offering Bribes, highlighting that the offering of bribes can be punished by imprisonment, fines, forfeiture of illegal gains and even suspension of future bidding rights in government procurement programmes. In December 2022, the SPP circulated the Guiding Opinions on Strengthening the Handling of Crimes of Offering Bribes, which emphasised prosecution of both companies and individuals, clarifying that individuals who pay bribes in the company’s name while also gaining personal benefits (such as enhancing sales performance to get more bonus) can be prosecuted as an individual bribe-payer, even if the company is not criminally liable. According to reports released during the 20th National Congress of the Communist Party of China (CPC) in October 2022, approximately 48,000 people were criminally investigated for offering bribes, which accounted for nearly 80 per cent of all investigations against bribe-givers in the past 10 years. Following this trend, internet companies such as Alibaba, Tencent, Baidu and Didi pledged their efforts to eliminate internal corruption. For instance, Tencent fired more than 100 people and blacklisted 23 business partners in 2022 in an attempt to curb bribery.
Second, China has continued to promote its pilot corporate compliance for non-prosecution system. In April 2022, the SPP announced nationwide corporate compliance reform and issued the Measures for Compliance Creation, Evaluation and Review of Enterprises Implicated in Criminal Cases (Trial Implementation) (the Measures) jointly with eight other departments. The Measures outline key factors to evaluate whether a corporate compliance system is robust, including timely handling of misconduct and a well-functioned mechanism to investigate misconduct, and specifies that adequate compliance will lead to a downgrade in arrest, prosecution, sentencing and punishment recommendations.
In terms of commercial bribery, in November 2022, SAMR published the Draft Amendment to the Anti-Unfair Competition Law of the People’s Republic of China (AUCL) for public comments (the Draft Amendment). The Draft Amendment (1) specifies that instructing others to give bribes constitutes commercial bribery; (2) expressly includes ‘counterparties in transactions’ as bribe recipients, not merely ’employee of counterparties in transactions’ as stated in the current AUCL; (3) explicitly prohibits the acceptance of commercial bribery; and (4) raises the maximum fine for commercial bribery from 3 million yuan to 5 million yuan.
The healthcare sector remains a focal point of anti-corruption enforcement in China. In May 2022, nine Chinese ministries jointly issued the Notice on the Key Working Points of Correcting the Unhealthy Practice in the Field of Pharmaceutical Purchase and Sales and Medical Services in 2022, demonstrating the government’s continued focus on rectifying illegal practices such as kickbacks, commercial bribery and fabrication of receipts, etc., in the life sciences field. In November 2022, SAMR issued five representative commercial bribery cases, targeting the healthcare industry and public procurement sector to combat unlawful kickback and corruption.
Moreover, China imposed stricter restrictions on private investments by government officials’ families. In June 2022, CPC promulgated the Regulations on Business Activities of Government Officials’ Spouses and Children, requiring senior government officials to report all business activities of their spouses and children, particularly investments in companies and management positions at private equity firms or foreign-owned enterprises.
Chinese antitrust enforcement
The year 2022 witnessed China’s continued efforts in promoting antitrust legislation and carrying out enforcement activities. The amended AML, effective from 1 August 2022, has been the first amendment to the AML since its inception in 2008. The amended AML emphasises the fundamental role of competition policies in China’s market economy and introduces several key changes, including, most notably, an enhanced penalty regime. The amended AML (1) increases penalties from 500,000 yuan to 5 million yuan for failure to obtain prior regulatory approval or clearance for merger and acquisition transactions, (2) introduces for the first time administrative fines against individual principals and employees responsible for entering into anticompetitive agreements, and (3) imposes a punitive fine equal to two to five times the initial amount of a fine for particularly serious antitrust violations. The amended AML also takes a more relaxed approach towards resale price maintenance (RPM) – namely, if an undertaking concerned can prove that the RPM does not bring about anticompetitive effects, such RPM conduct would not be per se illegal.
In June 2022, aiming to harmonise existing rules following the amended AML, SAMR released six sets of draft AML implementing rules (the Rules) for public consultation. The Rules cover the implementation details of the amended AML in areas including merger review, monopoly agreements, abuse of dominance, abuse of IP rights and abuse of administrative powers. In November 2022, the Supreme People’s Court released the Draft Provisions of the Supreme People’s Court on Several Issues concerning the Application of Law in the Trial of Monopoly Civil Dispute Cases and announced 10 recent exemplary antitrust litigation cases between 2020 and 2022, which provided more clarity on antitrust issues, such as links between administrative enforcement and judicial proceedings, initiation of public interest lawsuits against antitrust infringers and considerations in damage calculation for plaintiffs, etc. SAMR’s Draft Amendments to AUCL in November 2022 also increases the fines from 3 million yuan to 5 million yuan for anticompetition behaviours such as malicious trading and using technical means to influence user choices.
On the enforcement front, scrutiny of internet platforms remains one of the top priorities. For example, in December 2022, SAMR imposed on China National Knowledge Infrastructure (CNKI), a leading online knowledge database service provider in China, a fine of 87.6 million yuan (equivalent to 5 per cent of its sales value in 2021) for abuse of dominance through exclusive dealing and excessive pricing. CNKI was found to have a dominant position in the Chinese-language academic literature online database services market in China with a market share of more than 50 per cent. According to SAMR’s findings, CNKI had abused its dominance between 2014 and 2021 by (1) imposing exclusivity requirements on its customers so that their academic work was prohibited from being published on CNKI’s competing platforms and (2) inflating the pricing of its services by more than 10 per cent annually on average, which is substantially higher than the pricing increases of 4 per cent or lower annually by its competitors. In 2022, SAMR announced a total of 38 antitrust enforcement decisions against internet technology companies, including Alibaba, Sina, Tencent, Didi, Bilibili and JD.com, for failing to seek regulatory approval in advance of the mergers and acquisitions they conducted. This indicates China’s persistent efforts in scrutinising internet platforms for compliance with competition policies.
Enforcements in other traditional livelihood-related sectors showed no sign of slowdown in 2022. For instance, in July 2022, the Beijing Administration for Market Regulation (Beijing AMR) issued the first RPM enforcement case in a franchise context. The Beijing AMR imposed a fine of 942,386 yuan on Beijing Kairui Alliance Education Technology (Kairui) because Kairui coerced its franchisees to offer English courses at fixed prices set by Kairui in its franchising operation. In another case in July 2022, Shaanxi Cement Association (the Association) and 13 member companies were found by the Shanxi Administration for Market Regulation (Shaanxi AMR) to have discussed price hikes and simultaneously increased prices for certain cement products. A total fine of approximately 450 million yuan was imposed on the 13 member companies for price-fixing, and a further 500,000 yuan was imposed on the Association for organising these member companies to conduct anticompetitive activities, setting a record high sanction in the Chinese building material sector. More recently, in December 2022, Northeast Pharmaceutical Group Co, Ltd disclosed that it was fined 133 million yuan for abuse of dominance by selling levocarnitine active pharmaceutical ingredients at unfairly high prices. Such high penalties underscored growing regulatory scrutiny over antitrust violations in China.
iv Chinese outbound M&A
Chinese outbound investment approval and filing regimes
A proposed outbound investment in overseas target assets by a Chinese investor is subject to a series of outbound investment approval, filing and reporting requirements with competent Chinese authorities depending on, inter alia, the location and industry of the target assets, the investment amount, and the identity and ownership structure of the Chinese investor. An outbound investment made by Chinese individual investors through onshore or controlled offshore vehicles will be subject to relevant NDRC and MOFCOM filing or reporting mechanisms.
NDRC regulates Chinese companies’ outbound investment activities on a project-by-project basis through a multilayered approval and filing regime. Under the Administrative Measures for Enterprise Outbound Investment (Regulation No. 11), which took effect on 1 March 2018, a Chinese investor is required to make a filing with NDRC or its local counterpart (depending on whether the Chinese investor is a centrally managed SOE and whether the investment size (including equity and debt investments made by not only the Chinese investor but also the offshore entities controlled by the Chinese investor) reaches US$300 million) and obtain an NDRC filing notice for an outbound investment transaction that does not involve a ‘sensitive country or region’ (countries and regions that are subject to investment restrictions under international treaties, war or civil commotion, or that have no diplomatic relations with China) or a ‘sensitive industry’ (which was further clarified by NDRC in 2018 (see below for more details)). In cases where the transaction involves a sensitive country or region or a sensitive industry, the Chinese investor is required to apply for and obtain an outbound investment approval from NDRC. In parallel with Regulation No. 11, NDRC promulgated a Catalogue of Sensitive Industries for Outbound Investment 2018 (the Sensitive Industries Catalogue) in January 2018, with effect from 1 March 2018, and released the Answers to Frequently Asked Questions Concerning Outbound Investment by Enterprises (the Answers to FAQs) in June 2018 on its website (which was updated in July 2021), providing clarification for frequently asked questions regarding the application of Regulation No. 11. NDRC made rather restrictive interpretations of the scope of sensitive projects. These industries or projects include real estate, hotels, offshore equity investment funds or investment platforms without specific underlying industrial projects, sports clubs, cinemas and the entertainment industry. The designation of real estate, hotels and offshore equity investment funds or investment platforms without specific underlying industrial projects as sensitive industries has drawn substantial attention, as there were significant amounts of investment made in these industries in terms of both deal numbers and deal values before 2018. Regulation No. 11 adopts a control-based approach that includes in the verification scope all sensitive projects made by offshore entities under the control of Chinese investors, regardless of whether or not the Chinese investors provide financing or guarantees for these projects. The Answers to FAQs also include detailed explanations and instructions for each of the sensitive industries to clarify the scope of sensitive projects.
Aside from the multilayered approval and filing regime implemented by NDRC, outbound investment transactions are also subject to the reporting and filing requirements implemented by MOFCOM. Under the Interim Measures for the Recordation (or Confirmation) and Reporting of Outbound Investment (Circular No. 24), which were promulgated by MOFCOM on 8 January 2018, each Chinese investor that conducts an outbound investment transaction shall file the details of the outbound transaction made by it with MOFCOM or its local counterpart. Circular No. 24 applies the same criteria under Regulation No. 11 for the initial filing or reporting of an outbound investment transaction. Circular No. 24 further requests the Chinese investor to update its filings with respect to the approved outbound investment transaction with the competent MOFCOM on a periodic basis. On 1 July 2019, MOFCOM promulgated the Implementation Regulation of Interim Measures for the Recordation (or Confirmation) and Reporting of Outbound Investment (Circular No. 24 Implementation Rules), which provide the filing requirements in detail. Under Circular No. 24 Implementation Rules, each Chinese investor shall file a semi-annual report with respect to the approved outbound investment every six months, which shall include, without limitation, the financial performance of the invested foreign business. If the Chinese investor encounters any problem with respect to the approved outbound investment (e.g., war, governmental default or a major health emergency), it shall promptly report the event to the competent MOFCOM.
NDRC approvals and filings and MOFCOM initial approvals and filings are typically the pre-closing procedures on the part of Chinese investors in outbound investment transactions, particularly if the Chinese investor needs to establish an offshore subsidiary or to use onshore financing (whether equity or debt financing), or both, to complete the transaction. If a Chinese buyer uses an existing offshore entity as the acquisition vehicle and has sufficient funds offshore to complete the transaction, NDRC approvals and filings and MOFCOM initial approvals and filings, and even registration with the State Administration of Foreign Exchange (SAFE) as described below, may not be required by the parties as closing conditions (although the Chinese buyer may nevertheless go through the process of obtaining and completing NDRC approvals and filings and MOFCOM initial approvals and filings to be able to repatriate funds from the relevant investment back to China in the future). However, the new NDRC outbound rules impose, as a new post-closing government filing, reporting obligations on an investment of US$300 million or more made by an offshore entity controlled by a Chinese investor utilising offshore financing.
After obtaining NDRC approvals and filings and MOFCOM initial approvals and filings, a foreign exchange registration with SAFE through a local Chinese bank is required for the currency conversion and remittance of the purchase price out of China. However, SAFE registration will not be applicable if a Chinese investor uses offshore capital to fund the transaction where there is no cross-border guarantee arrangement relating to such offshore capital source. Additionally, a foreign exchange registration would be required in the case of an earnest deposit to be paid from China to overseas immediately upon or within a short period of the signing of a definitive purchase agreement. Upon registration, a Chinese investor may remit the registered amount of the deposit to offshore. However, if a Chinese investor uses its offshore funds to pay the deposit, this registration may not be applicable. The registration can be handled by a local Chinese bank concurrently with the NDRC project confirmation process if the amount of the deposit does not exceed US$3 million or 15 per cent of the purchase price. Payment of deposits of higher amounts must be approved by SAFE on a case-by-case basis after completing the NDRC project confirmation process.
A Chinese SOE as a buyer may also need approvals from the State-owned Assets Supervision and Administration Commission of the State Council or its local counterpart, or sometimes, alternatively, approvals from its group parent company. Depending on the transaction value and structure, a company listed on a Chinese stock exchange may need to obtain stockholders’ approval before the closing of such transaction and make necessary disclosures as required by the rules of the stock exchange. The State Council requires the establishment of share capital systems for SOEs and improved auditing systems to monitor SOEs’ outbound equity investments. This principle, accompanied by current rules applicable to SOEs’ investments (e.g., appraisal), is regarded as intended to preserve and increase the value of state-owned overseas assets.
Since late 2016, it has been reported that the increasing flow of Chinese outbound investment has become a concern to Chinese authorities, who have adopted more stringent control and supervision of outbound investment activities and capital outflow. In an official press release dated 6 December 2016, certain central governmental authorities, including NDRC, MOFCOM and SAFE, in their response to a media enquiry on tightened scrutiny over outbound investment transactions, mentioned that they had been alerted to some irrational outbound investment activities in real estate, hotels, film studios, the entertainment industry and sports clubs, and potential risks associated with overseas investment projects involving large investments in businesses that are not related to the core businesses of the Chinese investors, outbound investments made by limited partnerships, investments in offshore targets that have assets of a value greater than the Chinese acquirers, projects that have very short investment periods and Chinese onshore funds participating in the going-private of offshore-listed China-based companies. Further, on 4 August 2017, the State Council issued the Guidance Opinions on Further Promoting and Regulating Overseas Investment Direction (the Guidance Opinions), which highlighted certain industry-specific guidance affecting Chinese outbound investments, including encouraging investments in overseas high-tech and manufacturing companies and in setting up overseas research and development (R&D) centres; promoting investments in agricultural sectors; regulating investments in oil, mining and energy sectors based on an evaluation of the economic benefits; restricting investments in real estate, hotels, cinemas, the entertainment industry and football clubs; and prohibiting investments in the gambling and pornography sectors. Under the Guidance Opinions, investments in offshore private equity funds or investment vehicles that do not have investment projects are classified as restricted investments, which would be subject to pre-completion approvals by NDRC. The aforementioned measures were formally adopted in the Sensitive Industries Catalogue promulgated in 2018.
The tightened control on outbound investment activities and capital flow not only affects Chinese investors but also is relevant to international private equity participants from at least two perspectives: when a private equity participant intends to partner with a Chinese investor in M&A activities outside China or when a private equity participant is considering a Chinese buyer for a trade sale as its exit route. In these scenarios, the private equity investor must take into account the potential risk that the Chinese party may not be able to come up with sufficient funds offshore in time to complete the transaction offshore or ultimately complete the transaction. Further, when private equity investors consider a Chinese buyer as a potential exit route, in addition to the completion risk, a private equity seller would be well advised to also consider the risk profile of the transaction and the target business in the context of Chinese regulations (including the relevant industry, the financing structure and the identity of the Chinese buyer) to evaluate the related risks and impacts, including reputational risks and social impacts if the Chinese buyer is required to divest the business shortly after completing the transaction or is unable to provide the required funding offshore for the business, which might put stress on various aspects of the operation of the business and might also force a premature sale.
Non-Chinese investment approvals
The United States, the European Union and other countries and regions scrutinise and regulate international business activities, including Chinese investments, to achieve objectives related to, inter alia, national security, foreign investment control and anti-monopoly. In connection with Chinese investments in the US or EU countries, the relevant parties should be aware of potential non-Chinese approvals that may be mandatory or necessary in the jurisdiction where the target is located, depending on the nature and size of the transaction, which may include US and EU merger control review and a Committee on Foreign Investment in the United States (CFIUS) review.
A CFIUS review is often perceived among parties to Chinese outbound investments in the United States as one of the major foreign regulatory hurdles. CFIUS is an inter-agency committee of the US government that is empowered to monitor foreign direct investment in the United States by a non-US person, to evaluate whether the transaction may create national security risks. CFIUS establishes the process for reviewing the national security impact of foreign investments, joint ventures and other investments into the United States, and analyses a broad range of national security factors to evaluate whether a transaction may create a national security risk to the United States.
On 13 August 2018, former US President Trump signed into law the Foreign Investment Risk Review Modernization Act (FIRRMA), which substantially reformed and expanded the jurisdiction and powers of CFIUS, including (1) expanding the jurisdiction of CFIUS to expressly include not only controlling direct investments but also certain non-controlling investments, (2) adopting a mandatory declaration process for certain covered transactions together with mandatory waiting periods for the closing of those transactions, (3) extending the statutory timeline in respect of the review process and (4) granting enforcement authority to CFIUS to suspend transactions. On 11 October 2018, CFIUS promulgated a pilot programme, which took effect on 11 November 2018, strengthening and detailing regulations affecting 27 identified industry sectors (e.g., R&D in biotechnology, petrochemical manufacturing, and semiconductor and related device manufacturing). To further enhance this pilot programme, on 17 September 2019, the US Department of the Treasury promulgated the Draft Implementation Regulation of FIRRMA (the Draft FIRRMA Implementation Regulation). The Draft FIRRMA Implementation Regulation introduces the concept of a ‘technology, infrastructure and data (TID) US business’ for the first time to further emphasise the gravity and sensitivity of foreign investment in business sectors relating to intellectual property, critical infrastructure and personal data. According to the Draft FIRRMA Implementation Regulation, CFIUS further expanded its jurisdiction to all ‘covered investments’, which includes any investment made by a non-US investor in a TID US business. On 13 January 2020, the US Department of the Treasury published the finalised Draft FIRRMA Implementation Regulation, which became effective on 13 February 2020. On 15 September 2022, US President Biden issued Executive Order 14083, which elaborates on the factors that CFIUS should consider concerning national security risks associated with any given transaction, including (1) effect on the resilience of critical US supply chains that may have national security implications, (2) effect on US technological leadership in areas affecting US national security, (3) industry investment trends that may have consequences for a given transaction’s impact on US national security, (4) cybersecurity risks and (5) risks to US persons’ sensitive data. As an example, CFIUS’s ongoing investigation of TikTok has been focused on personal data collection. On 20 October 2022, CFIUS released the first-ever CFIUS Enforcement and Penalty Guidelines, in which CFIUS describes the conduct that may constitute a violation, the process it follows in imposing a penalty and some of the factors it considers in determining the penalty and the scope of any such penalty. Neither Executive Order 14083 nor the CFIUS Enforcement and Penalty Guidelines mentioned any particular country, yet there are references to the threat posed by investments ‘directly or indirectly involving foreign adversaries and other countries of special concern’ that may present an unacceptable risk to the US national security ‘due to the legal environment, intentions, or capabilities of the foreign person, including foreign governments, involved in the transaction’. Given that Sino-US relations have deteriorated significantly in recent years, FIRRMA, the pilot programmes implemented by CFIUS and the Draft FIRRMA Implementation Regulation are likely to have a disproportionate impact on Chinese outbound investments into the United States, especially investments in highly sensitive areas (particularly, any TID US business and potential access to personal data of US citizens) in the near future.
According to the CFIUS annual report covering calendar year 2021 (the CFIUS Annual Report) released on 2 August 2022, CFIUS has ramped up its outreach on ‘non-notified’ transactions where CFIUS identified transactions not voluntarily filed through a variety of methods, such as inter-agency referrals, tips from the public, media reports, commercial databases or congressional inquiries, and requests submission of notification on the transactions for its consideration, a trend that will persist throughout 2023. In 2021, investors from China (including Hong Kong) made a total of 45 filings (44 joint voluntary notices and one declaration), up from a total of 26 filings in 2020 and 32 filings in 2019. Compared with investors from other countries, investors from China (including Hong Kong) filed the most notices in 2021, constituting 16.2 per cent of the total notices. Such an increase does not necessarily amount to an increase in foreign direct investment from China into the United States; instead, it results from the growing scrutiny and sensitivities, as well as the more aggressive non-notified process over Chinese investment in US companies. In practice, CFIUS has taken interest in transactions involving a seemingly benign investor or company based on actual or perceived exposure to Chinese influence as a result of such connections. The CFIUS Annual Report also indicated that the potential for transfer of export controlled technologies to third parties not directly related to the buyer can also be a source of national security risk.
Recent major Chinese outbound investment transactions abandoned or terminated on account of CFIUS issues are listed as follows:
- the abandonment in September 2022 of the US$57.94 million acquisition of Snapdragon Chemistry by Asymchem Pharmaceutical Group (Tianjin) Co, Ltd (listed on the Shenzhen Stock Exchange (SZSE));
- the abandonment in August 2022 of the US$1,083.8 million acquisition of the Maersk Container Industry by China International Marine Containers (Group) Co, Ltd (listed on HKEX and SZSE);
- the abandonment in December 2021 of the US$1.4 billion acquisition of MagnaChip Semiconductor Corporation (a South Korean semiconductor company listed on the New York Stock Exchange (NYSE)) by a Chinese private equity Wise Road Capital Ltd;
- the termination (through a presidential order) in March 2020 of the US$35 million acquisition of StayNTouch, Inc by Beijing Shiji Information Technology Co, Ltd and divestment of ownership and interest acquired;
- the abandonment in May 2018 of the US$23.2 million additional investment in UQM Technologies, Inc (listed on NYSE) by China National Heavy Duty Truck Group Co, Ltd (which will increase its ownership in UQM to 34 per cent);
- the abandonment in May 2018 of the US$9.9 million acquisition of 45 per cent share in Akron Polymer Systems by Shenzhen Selen Science and Technology;
- the termination in March 2018 of the US$16.5 million acquisition of Waldo Farms Inc by Beijing Dabeinong Technology Group;
- the abandonment in May 2018 of the US$200 million acquisition of a controlling stake in US hedge fund Skybridge Capital by HNA Group;
- the abandonment in February 2018 of the US$100 million acquisition of 63 per cent shares in Cogint Inc (listed on Nasdaq) by Bluefocus because of the parties’ failure to obtain CFIUS approval;
- the termination in February 2018 of the US$580 million acquisition of US semiconductor testing company Xcerra Corp by Hubei Xinyan Equity Investment Partnership because of the parties’ failure to obtain CFIUS approval;
- the termination in January 2018 of an attempted US$1.2 billion strategic acquisition of US money transfer company MoneyGram International Inc by Chinese financial service provider and affiliate of Alibaba, Ant Financial Services Group, because of CFIUS refusal of approval over national security concerns;
- the termination in November 2017 of a US$100 million investment in US financial services firm Cowen Inc by CEFC China Energy Company Limited;
- the executive order issued by former President Trump in September 2017 blocking a proposed US$1.3 billion sale of Lattice Semiconductor Corporation, a publicly traded US manufacturer of programmable logic chips, to a Chinese state-backed private equity firm;
- the abandonment in September 2017 of the US$285 million proposed 10 per cent equity investment in HERE Technologies by a part-Chinese consortium;
- the termination in July 2017 of the US$103 million acquisition of US in-flight entertainment company Global Eagle by the Chinese conglomerate HNA because of the parties’ inability to obtain CFIUS approval;
- the executive order issued by President Obama in December 2016 blocking the proposed acquisition of German semiconductor manufacturer Aixtron SE’s US business by a group of Chinese investors led by Fujian Grand Chip Investment Fund LP;
- the termination in January 2016 of the attempted acquisition of Philips NV’s Lumileds LED business by a consortium of Chinese investors led by GO Scale Capital because of the parties’ failure to address national security concerns raised by CFIUS;
- the termination in February 2016 of the proposed investment in Western Digital by Unis Union and Unisplendour after CFIUS determined to investigate the transaction; and
- the rejection by US chipmaker Fairchild Semiconductor International in February 2016 of a bid from China Resources Microelectronics citing an ‘unacceptable level’ of CFIUS risk.
Other countries have also tightened control over investment by Chinese companies in certain sensitive industries, which has resulted in the termination of certain acquisition attempts by Chinese companies. Germany enacted an amendment to the German Foreign Trade and Payments Ordinance (AWV) in July 2017, pursuant to which any acquisition of at least 25 per cent voting rights of German companies by a non-European Economic Area investor is subject to a foreign investment control approval by the German government. On 20 December 2018, Germany promulgated a new amendment to the AWV, lowering this threshold to 10 per cent for certain investments in ‘critical infrastructure’ or ‘military-related products’ industries. Notable examples of failed attempts by Chinese companies in Germany include an attempted takeover of the Westphalian mechanical engineering company Leifeld Metal Spinning on 1 August 2018 by Yantai Taihai, a leading participant in the Chinese nuclear sector. On 7 November 2022, the German government declared that it would block two prospective Chinese investments out of national security concerns, one of which was a Chinese takeover of Elmos Semiconductor’s chip factory; the other was a Chinese takeover of ERS Electronic. In 2022, Canada issued its Indo-Pacific Strategy, in which the section on China emphasised that Canada will ‘act decisively when investments from state-owned enterprises and other foreign entities threaten [its] national security’. In November 2022, three Chinese enterprises were ordered by Canada to divest from lithium mining companies, asserting that extraction of critical minerals raised growing national security concerns.
III Year in review
i Recent deal activity
The trend of US-listed Chinese companies going private heated up to record levels in 2015 and 2016, retreated from these peak levels in 2017, waned further in 2018 and 2019, revived in 2020, and cooled down in 2021 and 2022. Based on statistics obtained through searches on Thomson ONE, during 2014, four US-listed going-private transactions were announced (with four withdrawn) and three were closed; during 2015, eight US-listed going-private transactions were announced (with seven withdrawn) and 18 were closed; during 2016, eight US-listed going-private transactions were announced (with five withdrawn) and six were closed; during 2017, three US-listed going-private transactions were announced and one was closed; during 2018, five US-listed going-private transactions were announced (with one withdrawn); during 2019, four US-listed going-private transactions were announced and none was closed; during 2020, 15 US-listed going-private transactions were announced and six were closed; during 2021, five US-listed going-private transactions were announced and six were closed; and during 2022, six US-listed going-private transactions were announced and five were closed.
The struggle by some Chinese companies against market research firms and short sellers such as Muddy Waters Research, Citron Research and Blue Orca Capital has often provided interesting perspectives on the environment faced by Chinese companies listed in the United States. These market research firms and short sellers have gained name recognition by issuing critical research reports targeting Chinese companies listed in the United States. The business model of such firms appears to involve issuing negative research reports on a public company while simultaneously taking a short position in the company’s stock, which often enables these firms to make substantial profits even if their research and accusations are not ultimately proven correct. Notably, these firms have not limited their coverage to companies listed through reverse takeovers (RTOs),4 which are commonly considered to have lower profiles and to be more prone to disclosure issues than companies listed through a traditional IPO process.
Following the consequential coverage by Muddy Waters of Orient Paper Inc in 2010 and Sino-Forest Corp in 2011, the most notable case in 2012 arose when, on 18 July 2012, Muddy Waters published a scathing report on New Oriental Education & Technology Group Inc on its website, sinking the company’s share price to US$9.50 by 35 per cent in one day. New Oriental is widely considered one of the more reputable and well-run Chinese companies listed in the United States, and it went public in a traditional IPO. The company’s stock price subsequently recovered to US$13.90 one and a half months after the Muddy Waters report came out, suggesting the market’s belief that the accusations were not justified. On 14 November 2018, Blue Orca Capital issued a short-selling report, accusing Pinduoduo Inc, a social commerce company in China, of inflating revenues and falsely trimming losses. Blue Orca Capital predicted a 59 per cent drop in the company’s stock price in its negative report, whereas Pinduoduo’s stock price experienced a surge after the announcement of its quarterly result following Blue Orca Capital’s report, suggesting that investors in the US market as a whole can act quite independently of such negative research reports and short-selling attempts. On the other hand, on 24 October 2013, Muddy Waters published an 81-page report labelling Beijing-based mobile provider NQ Mobile Inc a ‘massive fraud’, sending the company’s share price tumbling more than 60 per cent in three days. NQ Mobile’s share price experienced substantial recovery during the fourth quarter of 2013 and the first quarter of 2014 but lost more than 80 per cent in value amid continued attacks from Muddy Waters and traded below US$4 (or less than one-fifth of its 2013 high) for most of 2017. NQ Mobile Inc was eventually delisted from the NYSE on 9 January 2019.
Regardless of the ultimate outcome, the fact that a single research report could inflict sudden and substantial damage of this nature on a company’s reputation and stock price strongly suggests a widespread underlying lack of confidence in listed Chinese companies. The success of these research and short-selling firms could also be partly attributed to a lack of access to and understanding of the Chinese business environment and markets, which have afforded a few firms that have conducted on-the-ground research outsize influence in the market. Further, their critical coverage, which often involves allegations of disclosure issues or even fraud, has attracted regulatory attention and shareholder lawsuits and may have encouraged less than generous media coverage of Chinese companies in general. For instance, in 2020, SEC requested delisting of the then Nasdaq-listed Luckin Coffee Inc (OTC: LKNCY), one of the hottest Chinese coffee brands, following the acknowledgement by the company of inflation of revenue (with a total inflated net revenue of 2.12 billion yuan according to the company’s internal investigation) through fabrication of sales since 2019 by its chief operating officer and several employees, which was alleged in a report and negative coverage issued by Muddy Waters early that year. Consequently, the company completed the delisting in June 2020 and settled with SEC on charges of fraud and accounting irregularities with US$180 million in monetary penalties in December 2020. The above factors, in turn, are believed to have contributed to suppressed valuations of US-listed Chinese companies in general.
Amid continued pressure from regulators, unfavourable media coverage, short-selling activities and shareholder lawsuits, the stock prices of many US-listed Chinese companies are perceived to be consistently depressed. Further, even Chinese companies relatively free of negative coverage have often felt that their business model and potential are not fully appreciated by the US market, and that they would be more favourably received by a market closer to China – for example, the HKEX or the Chinese A-share market – where market research and media coverage are seen as being more positive and reflecting a proper appreciation of the business culture and environment in China, resulting in a better understanding of the specific business models and potential of the companies covered. At the same time, the domestic Chinese stock market often offers more attractive valuations. The price-to-earnings (P/E) ratio of the Shanghai Stock Exchange Composite Index was 12.78 at the end of 2022, 18.02 at the end of 2021, 16.76 at the end of 2020, 14.55 at the end of 2019, 12.43 at the end of 2018, 18.08 at the end of 2017, 15.91 at the end of 2016 and 17.63 at the end of 2015. Shares listed on the SZSE had a P/E ratio of 23.44 at the end of 2022, 33.03 at the end of 2021, 34.51 at the end of 2020, 26.15 at the end of 2019, 20.00 at the end of 2018, 36.21 at the end of 2017, 41.21 at the end of 2016 and 52.75 at the end of 2015. By contrast, the P/E ratio of the Nasdaq Golden Dragon China Index, a market capitalisation weighted index comprising US-listed Chinese companies, was 8.37 at the end of 2022, 12.98 at the end of 2021, 36.18 at the end of 2020, 19.59 at the end of 2019, 19.83 at the end of 2018, 27.03 at the end of 2017, 19.07 at the end of 2016 and 22.84 at the end of 2015.
The disparity in valuation levels and perceived receptiveness naturally presented a commercial case for management and other investors to privatise US-listed Chinese companies, with the hope of relisting them in other markets. One of the most significant going-private transactions to date was the proposed acquisition of Qihoo 360 Technology Co Ltd by a consortium consisting of its co-founder and chair, Mr Hongyi Zhou, its co-founder and president, Mr Xiangdong Qi, and certain other investors, in a transaction valuing the NYSE-listed company at approximately US$9.3 billion (not taking into account rollover shares to be cancelled for no consideration). This deal was closed in July 2016. Other notable going-private transactions in recent years include the privatisation of SINA Corporation and 51job, Inc (see ‘Other notable transactions’, below, for details).
While earlier going-private transactions involving US-listed Chinese companies tended to run more smoothly, some more recent transactions of this type went through more eventful processes, suggesting that the challenges in completing such transactions have been increased by a more competitive deal-making environment with a shrinking pool of desirable targets and a more seasoned shareholder base. For example, in the going-private transaction of Nasdaq-listed Yongye International Limited, the initial bid of the buyer consortium led by Morgan Stanley Private Equity Asia and the company’s CEO failed to receive the requisite shareholders’ approval, and the transaction was approved in a subsequent shareholder meeting only after the buyer consortium raised its bid by 6 per cent. In the going-private transaction of hospital operator Chindex International Inc, the initial offer of US$19.50 per share from the buyer consortium comprising Shanghai Fosun Pharmaceutical, TPG and the company’s CEO was countered by a rival offer of US$23 per share received by the company in the ‘go-shop’ period, and the buyer consortium eventually had to raise its offer to US$24 a share to secure the transaction, raising the total price tag to US$461 million.
A more recent case that has been drawing market attention is iKang Healthcare. While the iKang special committee was considering a going-private proposal submitted in August 2015 by a consortium led by Ligang Zhang, its founder, chair and CEO, and FountainVest, in November 2015, the iKang board received a competing proposal from a consortium led by one of iKang’s main competitors, Meinian Onehealth Healthcare (Group) Co, Ltd, a Shenzhen-listed company. The founder-led consortium and the Meinian-led consortium then engaged in an intense publicity war, iKang’s board adopted a poison pill and Meinian increased its offer price for the second time. In June 2016, after the board of directors of iKang received a competing going-private proposal from Yunfeng Capital (a private equity firm co-founded by Alibaba Group Holdings Ltd’s Jack Ma and Focus Media Holdings’ David Yu) to acquire the entire share capital in iKang, both the founder-led consortium and the Meinian-led consortium withdrew their going-private proposals. After 21 months’ negotiation, a reorganised consortium led by Yunfeng Capital, Alibaba Group Holdings, Boyu Capital, Ligang Zhang and Boquan He, the vice president of iKang, managed to enter into a merger agreement on 26 March 2018, pursuant to which the reorganised consortium proposed an offer at US$41.20 per share (or US$20.60 per American depositary share (ADS) of the company), with a total value of approximately US$1.097 billion. This offer was approved by iKang’s general shareholders’ meeting on 20 August 2018, and the merger was closed and officially announced on 18 January 2019.
In addition, another going-private deal recently attracted public attention. A buyer consortium led by Centurium Capital and including CITIC Capital, Hillhouse Capital, Temasek Holdings and the management team first announced its indicative proposal to privatise the Nasdaq-listed China Biologic Products Holdings, Inc (China Biologic), a leading blood plasma-based biopharmaceutical company, for US$4.59 billion in cash on 18 September 2019. On 19 November 2020, the two sides reached an agreement for the consortium to purchase the outstanding shares of China Biologic not already owned by the consortium members at US$120 per share, implying a valuation of US$4.76 billion for China Biologic. The privatisation transaction was closed on 20 April 2021.
The going-private trend was not limited to entities resulting from an RTO. While companies listed through RTOs may be easier targets of short sellers, companies that listed in the United States through a conventional offering may be more appealing targets for private equity investors given that these companies are often perceived to be of higher quality and less likely to have accounting or securities law compliance issues, and thus are more likely to grab a higher valuation later on, whether in an IPO in a market closer to China or a trade sale. Indeed, all of the examples discussed above involved companies listed through a traditional IPO.
A majority of US-listed China-based companies involved in going-private transactions in recent years are incorporated in the Cayman Islands. Five of six US-listed China-based companies that announced receipt of a going-private proposal in 2022 were Cayman Islands companies, compared with three Cayman Islands companies of five US-listed China-based companies in deals announced in 2021, five Cayman Islands companies of seven US-listed China-based companies in deals announced in 2020, and two Cayman Islands companies of four US-listed China-based companies in deals announced in 2019. This was driven in part by the introduction of new merger legislation in the Cayman Islands in April 2011, which made statutory merger under the Cayman Islands Companies Act an attractive route to effect a going-private transaction. The merger process typically requires the buyer group to form a new Cayman Islands company that will merge with, and be subsumed by, the listed Cayman target. Under the 2011 amendments to the Cayman Islands Companies Act, the shareholder approval threshold for a statutory merger was reduced from 75 per cent to a two-thirds majority of the votes cast on the resolution by the shareholders present and entitled to vote at a quorate meeting, in the absence of any higher threshold in the articles of association of the target company. In addition, a merger under the Cayman Islands Companies Act is not subject to the ‘headcount’ test, which, prior to its abolishment in August 2022, was required in a scheme of arrangement, the primary route for business combination under the Cayman Islands Companies Act before merger legislation was introduced in the Cayman Islands. The headcount test required the affirmative vote of ‘a majority in number’ of members voting on the scheme, regardless of the amount or voting power of the shares held by the majority, which meant that a group of shareholders holding a small fraction of the target’s shares could block a transaction. The lower approval threshold makes mergers an attractive option when compared with either a ‘squeeze-out’ following a takeover offer, which would require the buyer to obtain support from 90 per cent of the shares, or a scheme of arrangement, which would involve added time and costs arising from the court-driven process and, prior to August 2022, substantial closing uncertainty on account of the headcount test.
Most of the going-private transactions that closed in 2018 and 2017 took between two and five months from the signing of definitive agreements to closing (the rest took five months or longer) and were structured as a one-step, negotiated merger (as opposed to a two-step transaction consisting of a first-step tender offer followed by a second-step squeeze-out merger, which is another common approach to acquiring a US public company). In a one-step merger, a company incorporated in a US state will be subject to the US proxy rules, which require the company to file a proxy statement with the SEC and, once the proxy statement is cleared by the SEC, to mail the definitive proxy statement to the shareholders and set a date for its shareholders’ meeting. Transactions involving affiliates (e.g., management) are further subject to Rule 13e-3 of the Securities and Exchange Act and are commonly referred to as ’13e-3 transactions’. A 13e-3 transaction requires the parties to the transaction to make additional disclosures to the public shareholders, including as to the buyer’s position on the fairness of the transaction. An important related impact is that, whereas the SEC reviews only a fraction of all proxy statements, it routinely reviews disclosure in 13e-3 transactions, which can lengthen the transaction process by several months. Further, companies incorporated outside the United States and listed on US stock exchanges (including recent going-private targets that often are incorporated in the Cayman Islands or the British Virgin Islands) are known as foreign private issuers (FPIs). While FPIs are not subject to the proxy rules, they are subject to 13e-3 disclosure obligations, and if they are engaged in a 13e-3 transaction, they would be required to include as an exhibit to their 13e-3 filings information that is typically very similar to a proxy statement prepared by a US domestic issuer. Accordingly, both a transaction involving a US domestic company and a 13e-3 transaction involving an FPI follow a comparable timetable for the purposes of SEC review.
The recent tightening of control on capital flows out of China, including regulations restricting Chinese onshore funds from participating in the going-private of offshore-listed China-based companies, may also create hurdles for going-private transactions of offshore-listed China-based companies as these transactions typically involve buyer parties or financing, or both, from China. It remains to be seen how long the tightened control on outbound capital flow will last and its exact impact on going-private transactions involving Chinese companies.
Another key recent trend in going-private transactions of US-listed Chinese companies that are incorporated in the Cayman Islands is the rise of dissenting shareholders in such deals. Many of the US-listed and Cayman-incorporated Chinese companies that have recently gone private are facing dissenting shareholder litigations under Section 238 of the Cayman Islands Companies Act by investors who claim that their shares are worth more than the offer price. Often, the buyer groups are accused of forcing through low-ball offers by virtue of their significant voting rights. Low-ball offers are possible partly because Cayman Islands law allows buyer groups to vote their shares, including super voting shares, together with the other shareholders, towards the two-thirds in voting power represented by shares present and voting at the shareholders’ meeting required for approval of the merger. For example, the buyer groups in the take-private of Mindray and Shanda Games held 63.1 and 90.7 per cent, respectively, in voting rights in the relevant target companies. Some private equity shareholders in going-private transactions have publicly complained or made Schedule 13D filings with the SEC about low-ball offers from Chinese buyout groups.
In January 2017, the Cayman Islands Grand Court delivered its interlocutory judgment regarding the Blackwell Partners LLC v. Qihoo case, in which it decided that interim payments could be requested by dissenting shareholders and granted by the court during the judicial proceedings for the merger transactions initiated under Section 238 of the Cayman Islands Companies Act. In April 2017, the Cayman Islands Grand Court delivered its ruling in the Shanda Games case, in which it found that the fair value of the shares owned by the dissenting shareholders (which were all funds managed by Hong Kong-based fund manager Maso Capital) was more than double the consideration offered in the take-private scheme (although the Cayman Islands Privy Council then partly scaled back such fair value by applying a ‘minority discount’ in the valuation method in its appellate decision in January 2020). These decisions, in hindsight, are perceived to be instrumental in shaping the dissenting shareholder landscape in the Cayman Islands. The Shanda Games case was the second Cayman court decision on fair value in a merger, and the first one that required the Cayman court to determine the value of a company with assets and business operations in China. While the Shanda Games decision further propped up expectations of dissenting shareholders of a court-determined fair value that is substantially higher than the price offered by the buyer group, the Qihoo decision (together with a few other similar decisions) perhaps dealt the more decisive blow by enabling the dissenting shareholders to recover interim payments (which are often equal to the price offering in the take-private) relatively soon after initiation of litigation, significantly reducing the cost of funds for dissenting shareholders.
Currently, several similar additional cases are pending in the Cayman Islands courts, and it remains to be seen whether future Cayman court decisions will balance market expectations and discourage speculative dissenters. One of the cases demonstrating these balancing efforts is the decision of the Cayman Islands Grand Court in the going-private transaction of eHi Car Services Ltd (eHi), the provider of passenger car rental services in China. In June 2018, the Cayman Islands Grand Court decided that the dissenting minority shareholder of eHi could not pursue a winding-up petition intended to delay, or to gain leverage for, a competing merger bid for the privatisation of eHi. To compete against a proposal at US$13.35 per ADS offered by a consortium led by Baring Private Equity Asia Limited and Ruiping Zhang, the chairman of eHi group, Ctrip Investment Holding Ltd, a dissenting minority shareholder of eHi, submitted a counter proposal at US$14.50 per ADS. This proposal, although at a higher offer price, was not recommended by the special committee to the board of directors of eHi because it was considered to be a last-minute increase from the price offered in the proposal submitted by Baring and the chair. Ctrip Investment Holding Ltd then presented a winding-up petition together with an immediate injunction to the Cayman Islands Grand Court. The court struck out the winding-up petition in its entirety on the ground of abusive use of the winding-up jurisdiction by the dissenting shareholder. Although a reorganised consortium led by Ctrip Investment Holding Ltd and Ocean Imagination LP eventually won the competing bid with a revised proposal at US$15.50 per ADS in May 2018, the Cayman Islands Grand Court’s decision in this case now stands as an exemplary case for the principle that a winding-up petition may not be used abusively by dissenting shareholders to avoid a going-private transaction.
Other notable transactions
Consolidations in the vying internet and technology industries in China have been soaring and hitting headlines for several consecutive years. In February 2015, Didi Dache and Kuaidi Dache, two of China’s leading ride hailing apps, announced their US$6 billion stock-for-stock merger, which was closed weeks thereafter, creating Didi Kuaidi (later rebranded as Didi Chuxing), one of the world’s largest smartphone-based transport service providers. In August 2016, Didi Chuxing announced its acquisition of Uber China (Uber’s China business), which was valued at around US$8 billion. After the transaction, Didi Chuxing was estimated to be worth around US$35 billion. Uber obtained a 17.7 per cent stake in Didi Chuxing and became the largest shareholder of Didi Chuxing, with other existing investors in Uber China, including Chinese search giant Baidu Inc, taking another 2.3 per cent stake in Didi Chuxing. In April 2015, NYSE-listed 58.com purchased a 43.2 per cent fully diluted equity stake in Ganji.com for US$1.56 billion, initiating the long-term strategic combination of these two major online classified providers in China. In October 2015, two major online-to-offline (O2O) service providers in China, the group buying service Meituan.com and restaurant review platform Dianping Holdings, announced a merger to create a US$15 billion giant player in China’s O2O market covering restaurant review, film booking and group buying businesses. In late October 2015, China’s largest online tourism platform, Ctrip, announced the completion of a share exchange with Baidu, Inc, through which it gained control of its rival, Qunar. The transaction formed a dominant player in the online trip booking market in China valued at US$15.6 billion. In January 2016, Meilishuo.com, a Chinese fashion retailer backed by Tencent Holdings Ltd (Tencent), announced its merger with its chief rival, Mogujie.com, to form the biggest fashion-focused e-commerce service provider in China with a valuation of nearly US$3 billion. In September 2017, the merger of two major online film ticketing platforms was announced between Maoyan (majority owned by Chinese television and film company Enlight Media) and Weying (backed by Tencent). Following the merger, the combined Maoyan-Weying entity will control 43 per cent of China’s online ticketing market, according to Enlight Media’s announcement. In April 2018, Ele.me, a leading online food order and local delivery services platform in China, announced the completion of its merger into Alibaba Group Holdings Limited (Alibaba), with a valuation of US$9.5 billion. Following the merger, Ele.me has become a part of the Alibaba ecosystem by complementing Alibaba’s current local services platform, Koubei, and providing extended synergies to Alibaba’s new retail business sector in the long run. In September 2019, Kaola.com, a leading cross-border e-commerce platform in China, announced the completion of its merger into Alibaba, with a valuation of US$2 billion. Kaola.com was one of the biggest competitors of Tmall.com (the core cross-border e-commerce platform of Alibaba) in the field of cross-border e-commerce business in China. Upon the merger, Kaola.com retains its trade name and independent operations, while the management team of Tmall.com took charge of the corporate governance of Kaola.com. On 14 April 2020, Jumei International Holding Ltd (Jumei), a leading fashion and lifestyle solutions provider in China, announced the completion of its merger with Jumei Investment Holding Ltd, a unit of Super ROI Global Holding Ltd, with a valuation of US$126.51 million. Following the merger, Jumei will have greater flexibility to focus on long-term business goals, including pursuing strategic truncations and acquisitions, without the constraint of the public market’s emphasis on quarterly earnings. On 28 September 2020, SINA Corporation (SINA), a leading online media company serving China and the global Chinese communities, announced that it has entered into a merger agreement, pursuant to which New Wave MMXV Ltd agreed to acquire the remaining 87.878 per cent interest in SINA for a total of US$2.59 billion in a leveraged buyout transaction, via an unsolicited management buyout offer. On 23 March 2021, SINA officially announced the completion of privatisation and delisting from Nasdaq in the United States. On 17 August 2020, Yintech Investment Holdings Limited (Yintech), a leading provider of investment and trading services for individual investors in China, announced that it has entered into a merger agreement, implying an equity value of Yintech of approximately US$540.2 million. On 19 November 2020, Yintech announced the completion of its merger with Yinke Merger Co Ltd. On 21 June 2021, 51job, Inc. (51job), a Chinese human resources and job search provider, announced a definitive agreement and plan of merger with Garnet Faith Limited, to be taken private for $5.7 billion. The deal is one of the largest deals recorded for a recruitment marketplace business. The consortium of investors that formed Garnet Faith Limited includes DCP Capital Partners, Ocean Link Partners, 51job’s CEO and co-founder Rick Yan and Japan-based recruitment giant Recruit Holdings, the company’s largest shareholder. On 8 November 2021, 51job announced that its privatisation plan could not be completed in the second half of 2021 as planned due to the regulatory changes in China. The company’s recent announcement notes that certain members of the buyer consortium have been ‘in consultation with Chinese regulators on recent regulatory changes’ and ‘a clear timeline to its completion cannot be provided at this time’. On 12 January 2022, 51job received a proposal from the consortium to reduce the merger consideration by approximately 28 per cent. 51job subsequently agreed to reduce the merger consideration by approximately 23 per cent and, on 6 May 2022, announced the completion of the merger.
Apart from the iconic mergers described above, the headline private equity investments in recent years focused primarily on China’s technology industries. In April 2018, Pinduoduo Inc, the leading ‘new-ecommerce’ platform, which features a team purchase model, announced the completion of its pre-IPO financing at a valuation of US$15 billion with Sequoia Capital and Tencent. In June 2018, Ant Financial Services Group, the leading online payment service provider and the financial arm of the Alibaba Group, announced the completion of its US$14 billion Series C financing (with a valuation of US$150 billion) from a series of private equity and sovereign funds, including Baillie Gifford & Co, BlackRock Private Equity Partners, Canada Pension Plan Investment Board, The Carlyle Group, General Atlantic LLC, GIC Special Investments, Janchor Partners, Khazanah Nasional Bhd, Sequoia Capital, Silver Lake Partners, T Rowe Price, Temasek Holdings and Warburg Pincus. In October 2018, ByteDance/Toutiao, the leading internet content platform in China, announced the completion of its pre-IPO financing at a valuation of US$75 billion from leading global private equity funds including General Atlantic, KKR, Primavera and SoftBank. In 2019, the highlights of private equity investments still targeted China’s information technology industries. In February 2019, Chehaoduo Group (Guazi.com/Maodou.com), the leading e-commerce platform for used vehicles in China, announced the completion of its pre-IPO financing at a valuation of US$1.5 billion with SoftBank Investment Advisers. In November 2019, Cainiao Network Technology, one of the leading internet-based logistics service providers in China, announced the completion of its US$3.3 billion series B financing pursuant to which Alibaba became the largest and controlling shareholder of the company. In December 2019, Kuaishou.com, the leading short video content provider and social platform in China, announced the completion of its pre-IPO financing at a valuation of US$3 billion from a series of private equity investors, including Boyu Capital, Sequoia Capital, Yunfeng Capital, Tencent and Temasek Holdings. On 18 September 2020, 58.com Inc, China’s largest online classifieds marketplace, announced the completion of its merger (representing a deal size of US$8.39 billion) with Quantum Bloom Group Ltd, whereby 58.com, General Atlantic, Ocean Link and Warburg Pincus will collectively hold 85 per cent of the company upon the completion. In February 2022, Innotron Memory, a China-based integrated design and manufacturing company specialising in dynamic random access memory, completed its US$4.7 billion Series C+ financing round with an investor consortium including Alibaba, Tencent and Yunfeng Capital.
Another noteworthy trend in recent years has been private equity investors’ participation in the mixed ownership reform of China’s SOEs, where Chinese SOEs introduce private investors as minority shareholders. The highlight of this trend was the US$2.4 billion acquisition in 2014 of a 21 per cent equity interest in China Huarong Asset Management Co, Ltd, one of the largest asset management companies in China, which was listed on the HKEX in 2015 by a consortium of investors including China Life Insurance (Group) Company, Warburg Pincus, CITIC Securities International Company Limited, Khazanah Nasional Berhad, China International Capital Corporation Limited, China National Cereals, Oils and Foodstuffs Corporation, Fosun International Ltd and Goldman Sachs. Warburg Pincus was reported to have bought the largest portion of the 21 per cent stake for close to US$700 million. In August 2017, Wealth Capital, a Beijing-based private equity firm, set up a 5 billion yuan investment fund in Beijing targeting SOEs undergoing mixed ownership reform in which the state-backed China Structural Reform Fund (a 350 billion yuan SOE restructuring fund backed by investors including China Chengtong Holdings Group, China Merchants Group and China Mobile) has invested and Wealth Capital acts as the fund manager, which is just one of many similar SOE reform-targeted funds that are being set up by state-owned capital and private equity funds across China.
Third-party debt financing continues to be available for acquisitions of Chinese companies by private equity investors. One key challenge, however, is that a Chinese target does not generally have the ability to give credit support (by way of guarantee or security over its assets) to a lender of offshore acquisition debt financing. Further, with a view to deleveraging and strengthening the economy, the Chinese authorities imposed various new foreign debt controls in 2018, which will impact on the availability of security and financing to be provided by Chinese entities and financial institutions. For instance, insurance companies have been restricted from providing outbound guarantees for offshore debt, domestic Chinese companies raising foreign debt have been subject to higher governance standards, local government entities have been prohibited from providing outbound guarantees for offshore borrowing and real estate companies have been restricted from using foreign debt in relation to real estate projects. The covid-19 pandemic further worsened the fundraising environment. In the first quarter of 2020, the amount and number of funds raised showed a year-on-year (YoY) percentage decrease, large-scale fundraising was impeded, the raising period was lengthened and previous funds were postponed to the current period to complete raising. The fundraising amount decreased by 19.8 per cent YoY in the first quarter of 2020, and, despite an increase of 8.5 per cent in the second quarter, ended the year with a YoY decline of 36.5 per cent. In 2021, China-focused US dollar-denominated funds raised US$28.4 billion, comfortably beating the 2020 total. However, nearly three-quarters of commitments were made before July, when Chinese regulators launched an investigation into the newly NYSE-listed Didi Chuxing. Following a string of other regulatory interventions, this development was enough to make investors hold fire. Old and new headwinds further dampened sentiment in 2022, which saw a 29.8 per cent YoY decrease in the amount raised by China-focused US dollar-denominated funds to US$20 billion.
Many of the going-private transactions of US-listed Chinese companies involved debt financing, with the terms of the financings reflecting various commercial and structural challenges. The acquisition debt is typically borrowed by an offshore acquisition vehicle with the borrower giving security over its assets (including shares in its offshore subsidiaries, including the target) to secure repayment of the debt. As was the case in 2011 and 2012, the typical lender in these transactions spanned a wide range of financial institutions, from international investment banks to Chinese policy banks and offshore arms of other Chinese banks.
The Focus Media financing remains the standout transaction among debt-financed going-private transactions, mainly due to the size (US$1.52 billion) and complexity of the debt financing facility and the large consortium of major international banks (Bank of America Merrill Lynch, Citibank, Credit Suisse, DBS Bank, Deutsche Bank and UBS) and offshore arms of Chinese banks (China Development Bank, China Minsheng and ICBC) that provided the financing. The 7 Days Inn financing was another notable debt-financed going-private transaction that was largely financed by a syndicate of Asian banks (Cathay United Bank, China Development Industrial Bank, CTBC Bank, Entie Commercial Bank, Nomura, Ta Chong, Taipei Fubon Commercial Bank, the Bank of East Asia and Yuanta Commercial Bank). The debt financing for the Giant Interactive take-private was also underwritten and arranged by a large syndicate of banks, including China Minsheng Banking Corp, BNP Paribas, Credit Suisse, Deutsche Bank, Goldman Sachs, ICBC International and JP Morgan, in an aggregate amount of US$850 million. It can perhaps be considered a positive signal for any future going-private transactions that such a large number of financiers were comfortable committing to funding this type of event-driven financing.
One notable development since 2015 is reflected in the going-private of Qihoo. Rather than obtaining the debt financing in US dollars offshore, the entire financing of a yuan equivalent of approximately US$3.4 billion was provided by one Chinese bank (China Merchants Bank (CMB)) onshore in yuan, with the buyer group having obtained the required Chinese regulatory approvals to convert the yuan funded by CMB into US dollars for payment of consideration to Qihoo’s shareholders offshore. It remains to be seen whether this relatively novel deal structure will gain popularity as both Chinese regulatory authorities and financial institutions gain more familiarity with this type of take-private transaction involving US-listed and China-based companies. The tightened control over outbound capital flow since late 2016 discussed above may deter the wide usage of this type of financing structure.
Another emerging trend in these offshore financing structures is that borrowers are seeking to access liquidity from the offshore debt markets in respect of what are essentially acquisitions of China-based businesses – including as a means to take out bridge financing originating outside Asia.
iii Key terms of recent control transactions
Deal terms in going-private transactions
Most Chinese going-private transactions have involved all-cash consideration. Among the US-listed going-private transactions that closed during 2017, the per share acquisition price represented an average premium of 17.5 per cent over the trading price on the day before announcement of receipt of the going-private proposal, according to statistics obtained through searches on Thomson ONE.
In a 13e-3 transaction (the going-private of a US-listed company involving company affiliates), the board of directors of the target typically appoints a special committee of independent directors to evaluate and negotiate the transaction and make a recommendation to the board. If the target is incorporated in the United States, the transaction almost inevitably will be subject to shareholders’ lawsuits, including for claims of breaches of fiduciary duties, naming the target’s directors as defendants. Because the target’s independent directors often include US residents, a key driver of a transaction’s terms is the concern for mitigating shareholders’ litigation risk. Although no litigation claims for breach of fiduciary duties in a Chinese going-private transaction involving Cayman Islands or British Virgin Islands companies were reported to the public in 2017, it remains possible that, as the going-private trend persists, plaintiffs’ firms will begin to articulate creative arguments in Cayman mergers and the Cayman courts may look to the body of Delaware law as persuasive precedent for adjudicating claims of breach of fiduciary duties. As a result, whether a going-private transaction involves a US- or Cayman-incorporated target, targets typically insist that certain key merger agreement terms (in addition to the deal process) be within the realm of what constitutes the ‘market’ for similar transactions in the United States.
An important negotiated term in many going-private transactions is the required threshold for shareholder approval. Delaware law requires that a merger be approved by shareholders owning at least a majority of the shares outstanding. However, special committees often insist on a higher approval threshold because under Delaware law the burden of proving that a going-private transaction is ‘entirely fair’ to the unaffiliated shareholders often shifts from the target directors to the complaining shareholders if the transaction is approved by a majority of the shareholders unaffiliated with the buyer group (i.e., a ‘majority of the minority’). In US shareholder litigations, this burden shift is often seen as outcome determinative. Under Cayman law, there is no well-defined benefit for the company to insist on a higher approval threshold than the statutory requirement of two-thirds of the voting power of the target present at the shareholders’ meeting.
Another key negotiation point is whether the target would benefit from a go-shop period, which is a period following the signing of a transaction agreement during which the target can actively solicit competing bids from third parties. When defending against a claim of breach of fiduciary duties in Delaware, a company and its directors may point to a go-shop period in a merger agreement as a potentially helpful fact. Under Cayman law, however, there is not as much well-defined benefit for the company to insist on a go-shop period if the buyer consortium already has sufficient voting power to veto any other competing merger proposal.
Deal terms in growth equity investments
Deal terms are more difficult to evaluate and synthesise in private transactions, where terms are not publicly disclosed. Generally, in the context of a growth equity investment (which, as we have seen, remains the dominant type of deal both by number of deals and by aggregate amount invested), private equity investors often continue to expect aggressively pro-buyer terms. This expectation applies whether a transaction involves an onshore Sino-foreign joint venture or an investment offshore alongside a Chinese partner. In a subscription agreement for a growth equity deal, an investor typically benefits from extensive representations and warranties against which the company makes only limited disclosures; in some cases, an investor has knowledge that some representations may not be accurate, but still insists on a representation to facilitate a potential indemnification claim later. It is not uncommon for an investor to also enjoy an indemnity provision with a cap on the amount of losses subject to indemnification as high as the purchase price (or no cap at all), but with no deductible or de minimis threshold and with a long or even unlimited survival period (subject to statute of limitation). Shareholders’ agreements often contain similarly pro-investor terms, such as extensive veto rights (even in the case of a relatively small minority stake) and various types of affirmative covenants binding the company and its Chinese management or controlling shareholders. If an investment is structured offshore (e.g., through a Cayman Islands company that owns a Chinese subsidiary), a private equity investor (typically holding preferred shares) may enjoy ‘double-dip’ economics pursuant to which, in the event of a liquidation or sale of the company, the investor is entitled to, first, a liquidation preference before any of the Chinese management or controlling shareholders (typically holding ordinary or common shares) receive any proceeds and, second, the investor’s pro rata share of the remaining proceeds based on the number of shares it owns on an as-converted basis. However, because there is no well-defined market when it comes to transaction terms in Chinese growth equity deals (unlike in going-private transactions), issuers also have opportunities to request, and sometimes obtain, terms that are very favourable to them. In growth equity deals in China, investors typically seek valuation adjustments or performance ratchet mechanisms, which can be structured as the adjustment to conversion prices of preferred shares that may be exchanged into a larger number of common shares at offshore level, or by compensation or redemption of equity interest in cash or transfer of equity interest to investors by the founders or original shareholders at onshore level without consideration or for nominal consideration, so as to achieve adjusted valuation of the target company following the failure to meet specified performance targets. In Chinese growth equity investments, the parties’ leverage and degree of sophistication are more likely to dictate the terms that will apply to a transaction than any market practice or standard. In recent years, growth equity investments into high-growth technology companies have begun to contain less investor-friendly deal terms (e.g., new investors receiving pari passu liquidation preference with previous investors) as competition among private equity firms to make investments into this sector continues to heat up.
For a private equity investor with sufficient commercial leverage, the key challenge often lies not in convincing the investee company or its Chinese management or controlling shareholders to agree to adequate contractual terms, but rather in getting comfort that an enforceable remedy will be available in the event that the Chinese counterparty reneges on its contractual obligations. One potential antidote to the difficult enforcement environment onshore is to seek a means of enforcement offshore. An investor can get comfort if it obtains, for example, a personal guarantee of the Chinese founder backed by assets outside China governed by New York or Hong Kong law and providing for arbitration in Hong Kong as a dispute resolution venue. Such a guarantee, however, is rarely available (because the Chinese founder may not have assets outside China) and, even when potentially available, is often unacceptable to the founder. A more realistic alternative is for a private equity investor to seek the right to appoint a trusted nominee in a chief financial officer or similar position (who could monitor an investee company’s financial dealings and compliance with its covenants to its shareholders). An investor may also seek co-signatory rights over the target company’s bank account, in which case an independent third party (the bank) will ensure that funds are not released other than for purposes agreed to by the investor.
The recent wave of privatisation of Chinese enterprises in the US markets was stirred in 2020 by the passage of the HFCAA (see details in Section II.iii), which requires auditors of foreign public companies to allow the PCAOB to inspect their audit work papers for audits of non-US operations (which potentially clashes with applicable accounting and securities regulations in China) or face the risk of compulsory delisting. The privatisation wave was also spurred by enhanced scrutiny by US securities regulatory authorities over the VIE structure commonly adopted by China-based companies and the regulatory spotlight shed on cybersecurity and data security concern in overseas listing (by making an example of Didi Chuxing, which has announced its plan to delist from the NYSE and pursue a listing in Hong Kong) by Chinese authorities in 2021. Meanwhile, in November 2021, the HKEX published a set of new policies (including a lower minimum valuation threshold and a more relaxed listing structure) to accommodate secondary listing of Chinese enterprises delisted from the US market. According to a Reuters article,5 by the end of 2021, among 240 US-listed China-based companies, 19 completed Hong Kong listings, accounting for approximately 70 per cent of the aggregate market value of such companies, and, among the remaining companies, 27 would satisfy the Hong Kong listing standards, representing a total market value of US$250 billion. In 2022, 11 US-listed China-based companies completed Hong Kong listings, compared with seven in 2021. This homecoming trend may be counteracted by recent alleviation in US regulatory risks primarily as a result of the agreement reached in August 2022 among the PCAOB, China Securities Regulatory Commission and MOF granting the PCAOB access to inspect and investigate registered public accounting firms in mainland China and Hong Kong, followed by the PCAOB’s announcement in December 2022 that it had secured complete access to do so and vacated its previous determinations in December 2021 to the contrary (see Section II.iii for details). According to Reuters, Pinduoduo Inc (Nasdaq: PDD) and Full Truck Alliance Co (NYSE: YMM) have put discussions about a potential Hong Kong listing on hold following the PCAOB’s announcement.6 Given such developments, coupled with relatively relaxed financial standards and audit requirements, the US securities market is expected to remain attractive to middle- to small-sized China-based companies (generally those with a market value lower than US$0.1 billion or that are still in the red) that fall short of the listing standards for China A-Share or HKEX main board. Another noteworthy development was the issuance by HKEX of a consultation paper on new listing rules for ‘specialist technology companies’ in October 2022. Expected to come into effect in the first half of 2023, this new listing regime is intended to lower the bar for technology companies specialising in a defined range of sectors, such as artificial intelligence, semiconductors and nanomaterials, to list on HKEX main board.
With respect to transactions involving special purpose acquisition companies (SPACs), both SPAC offerings and de-SPAC mergers witnessed significant growth in Asia since the pandemic. As SPACs move to the mainstream of M&A transactions, private equity firms begin to sponsor acquisition vehicles even though SPACs represent their direct competitors for private assets in a traditional sense. On the other hand, de-SPAC mergers create new exits to private equity investors by providing a fast track to the public market. On the target side, however, China-based targets may be less attractive to sponsors given the recent capricious regulatory environment and heightened geopolitical risks, compared with targets in other regions in Asia. In December 2021, HKEX introduced its SPAC listing regime, creating another listing venue for SPAC deals involving China-based targets and providing more liquidity opportunities to private equity funds. Since then, five SPACs have listed on HKEX, none of which has completed a de-SPAC merger. It remains to be seen whether Hong Kong SPAC activities, both SPAC offerings and de-SPAC mergers, will pick up as market conditions improve.
Sponsor-to-sponsor sales contributed 33 per cent of the exit proceeds in Asia in 2020, up from 21 per cent in 2018. This trend accelerated as 2021 progressed, reaching US$17.8 billion in the fourth quarter, roughly twice the total of the preceding quarter, though capital was concentrated in a relatively small number of deals. Sponsor-to-sponsor sales similarly gained traction in China, generating 68.8 per cent of private equity-backed exit proceeds in China in 2022, compared with 16.4 per cent in 2021 and 5.5 per cent in 2020, quadrupling in volume from US$677.8 million in 2020 to US$2.7 billion in 2022. In January 2022, Hong Kong-based Baring Private Equity Asia completed its sale of customised technology solutions provider Interplex (which has significant operation in China) to private equity funds managed by Blackstone Inc for an enterprise value of US$1.6 billion. Sponsor-to-sponsor deals provide opportunities for private equity investors to be more creative in generating value. While such deals have previously been viewed as inefficient due to repeated transaction fees and other costs, involvement of private equity firms on both sides has the benefit of speeding up the entire transaction process. For example, the due diligence process in sponsor-to-sponsor deals can be completed at a faster pace compared with other transactions and, as such, the extra time saved allows private equity investors to focus more on strategy and creative solutions. As current market conditions and the regulatory environment have made IPOs a less attractive exit option, the option to sell to a strategic buyer that is looking for growth or another peer private equity firm that has the ability to capitalise on synergies and take the company to a new performance level seems to be a win-win alternative.
IV Regulatory developments
i Legal developments in cybersecurity and data security
Ever since the implementation of the National Security Law in 2015 and the Cybersecurity Law (CSL) in 2017, cybersecurity and data security have been brought into the dimension of overall national security. Together with the Data Security Law (DSL) and the Personal Information Protection Law (PIPL), both of which were promulgated and implemented in 2021, these laws constitute the basic legal framework on data governance in China, each with different emphases: the National Security Law, CSL and DSL focus on the protection of national security and public interests, whereas PIPL focuses on protection of personal information rights and interests during the processing of personal information. Cybersecurity and data security, as two separate but intertwined regimes, experienced a booming year in 2021 and the trend continued in 2022, with the issuance of more than 50 new laws and regulations, amendments and legislation drafts from central to local levels, across different departments and industries over the past two years.
A noteworthy development in 2022 is the promulgation by the Cyberspace Administration of China (CAC) of the Measures for Cybersecurity Review (the 2022 Cybersecurity Review Measures) (which came into effect on 15 February 2022) (the 2022 Measures), which repealed and replaced the old Measure for Cybersecurity Review promulgated in 2020. Pursuant to the 2022 Measures, critical information infrastructure operators that purchase network products and services and online platform operators (defined under the Draft Data Security Regulations as data processors that provide internet platform services such as internet publishing, social networking, online transactions, payments or audiovisual services) that are engaged in data processing activities are subject to cybersecurity review if their activities pose or may pose risks to national security. Cybersecurity review may be initiated by notice of the Cybersecurity Review Office of CAC under the interagency cybersecurity review working mechanism, either through voluntary application by a critical information infrastructure operator that anticipates national security risks in its procurement activities or through mandatory application by an online platform operator that possesses the personal information of more than one million users and seeks foreign listing (typically interpreted to exclude Hong Kong but include foreign countries such as the United States, subject to further official clarification).
Both the Draft Overseas Listing Administrative Provisions and the Draft Overseas Listing Filing Measures (see Section IV.ii, below) mandate that clearance of cybersecurity review (if applicable) is a precondition for a successful filing with CSRC for overseas securities offering and listing by a domestic enterprise. If it is found through cybersecurity review that the overseas listing may compromise national security, the domestic enterprise may be required to divest the relevant business or assets or to take other actions to prevent and avoid the impact on national security. If the domestic enterprise conducts the overseas securities offering and listing despite the cybersecurity risks, the domestic enterprise will be warned by CSRC, CAC or other regulators under the State Council and may be liable for a fine of more than 1 million yuan but less than 10 million yuan; suspension of business or revocation of licences or permits (including business licences) may also be imposed for severe violations. The controlling shareholder, actual controller, directors, supervisors and senior officers of such domestic enterprise, as well as the underwriters and law firms providing services in the overseas securities offering and listing (that fail to fulfil their duties to supervise and urge the enterprise to comply with the relevant regulatory requirements), may also receive a warning and be liable for a fine of more than 0.5 million yuan but less than 5 million yuan.
The Draft Data Security Regulations set a clear distinction among going public abroad, in Hong Kong and overseas (interpreted as including both Hong Kong and foreign countries). For a data processor that seeks to go public abroad and that handles personal information of more than one million users, a cybersecurity review is mandatory. For a data processor that seeks to go public in Hong Kong that has or may have an impact on national security, it shall also apply for mandatory cybersecurity review (i.e., Hong Kong listing does not provide a safe harbour for cybersecurity review in case of any national security implication). For a data processor that handles important data or seeks to go public overseas, annual data security assessment shall be conducted (either by itself or by data security service providers), and an annual assessment report shall be submitted to local counterparts of CAC.
On 31 August 2022, CAC issued the Application Guidelines for Security Assessment of Cross-border Data Transfer (First Edition), which contain the provisions on cross-border data transfer security assessments in the Measures for Security Assessment of Cross-border Data Transfers. The guidelines clarify the application scope of security assessments; stipulate the means, procedures and materials required for the application; and provide contact information for enquiries regarding the application. The guidelines also contain template documents, which offer useful guidance and assistance to data processors that seek a security assessment.
On 12 September 2022, CAC released the Decision on Amending the Cybersecurity Law (Draft for Comment), pursuant to which more stringent legal liabilities for certain violations of CSL and systematically consolidated and unified penalties for violating security protection obligations relating to network operations, network information, critical information infrastructure and personal information are expected to be imposed when the amendment becomes effective. The draft echoes Article 66 of PIPL by raising the maximum fines for personal information processors to 50 million yuan or 5 per cent of the offender’s turnover in the preceding year. The draft proposes to increase the maximum fines for persons directly liable to up to 1 million yuan and adds the penalty of prohibiting such persons from taking management or key cybersecurity protection positions. For violations of national security review requirements for procurement by critical information infrastructure operators, the draft proposes to increase the maximum fines to 5 per cent of the offender’s turnover for the preceding year.
Notably, Didi Global Inc (Didi) was fined 8.026 billion yuan (approximately US$1.2 billion) on 21 July 2022 following a cybersecurity review of more than a year initiated by CAC. This marks the largest penalty meted out for a breach of cybersecurity and data protection regulations. The penalty decision was made based on relevant clauses in CSL, DSL and PIPL, but DSL and PIPL only came into effect on 1 September 2021 and 1 November 2021, respectively, which were several months after the commencement of the investigation. CAC retrospectively applied DSL and PIPL in this case and justified doing so in a statement that Didi had continuously violated the CSL, DSL and PIPL for over seven years since June 2015. A personal penalty (1 million yuan (approximately US$148,000)) was also imposed on Didi’s chair and CEO, Wei Cheng, and president Qing (Jean) Liu, respectively. CAC said it had previously found that Didi had engaged in data processing activities that ‘seriously affect national security’ and had also violated other laws and regulations, including refusing to cooperate on certain requirements of the regulatory authorities and intentionally evading supervision. It also stated that Didi’s illegal operations had posed serious security risks to China’s critical information infrastructure and data security. This case is the first major cybersecurity penalty levied by CAC since the aforementioned cyber and data security laws came into effect, and it also indicates an increase of intensity of law enforcement in the cybersecurity and data security regime.
ii New developments on overseas listings of domestic companies
A series of new guidelines on overseas listings of domestic companies were promulgated and implemented in 2022 and drew widespread attention and aroused heated discussions. The Negative List (2021 Edition), which took effect on 1 January 2022, for the first time expressly states that domestic enterprises operating in prohibited sectors will have to seek permission from the regulator that regulates its business before listing overseas, and, if approval is given, foreign investors may not hold more than 10 per cent individually or more than 30 per cent in the aggregate of the shares of such enterprise and no foreign investor can participate in the management of such enterprise.
On 23 January 2022, CSRC completed and closed the collection of comments for the Administrative Provisions of the State Council Regarding the Overseas Issuance and Listing of Securities by Domestic Enterprises (Draft for Comments) (the Draft Overseas Listing Administrative Provisions) and the Measures for the Overseas Issuance of Securities and Listing Record-Filings by Domestic Enterprises (Draft for Comments) (the Draft Overseas Listing Filing Measures). The Draft Overseas Listing Administrative Provisions and the Draft Overseas Listing Filing Measures regulate the system, filing management and other related rules in respect of the direct or indirect overseas (typically interpreted to include Hong Kong) issuance of listed and traded securities by domestic enterprises and provide directional guidance to China’s reform plan on the supervision of overseas listing. The types of overseas issuance and listing of securities regulated by the Draft Overseas Listing Administrative Provisions include a ‘direct listing’, where the domestic enterprise (a company limited by shares) issues public securities to be listed and traded on an offshore stock exchange such as the stock exchanges in Hong Kong and the United States, and an ‘indirect listing’, where the domestic enterprise’s non-PRC parent whose primary business activities are in China acts as the issuer and the determination of whether the listing standards are met is based on the equity, assets or income of the domestic enterprise or the rights and interests relating thereto (including the rights to control or manage the domestic enterprise through a VIE structure). The Draft Overseas Listing Administrative Provisions introduced a filing-based system where domestic companies seeking for direct or indirect overseas securities offering and listing shall first complete filing procedures with CSRC before such securities offering and listing. For indirect overseas listing of domestic enterprises, pre-filing is required if both of the following criteria are met: (1) the operating income, total profits, total assets or net assets of the domestic enterprise in the latest accounting year account for more than 50 per cent of the relevant data in the issuer’s audited consolidated financial statements for the same period; and (2) most of the senior officers in charge of business operations and management are Chinese citizens or have habitual residence within the territory of China, and the main business operations are located or carried out mainly within the territory of China. Furthermore, the Draft Overseas Listing Administrative Provisions expressly provide that CSRC’s jurisdiction extends not only to listed securities but also to depository receipts, convertible corporate bonds and other equity instruments. In other words, the different securities offering and listing models, such as IPOs, DPOs, RTOs and SPACs, will all be subject to CSRC’s jurisdiction under the Draft Administrative Provisions. To complete the filing, the domestic enterprise shall present, among other things, opinions from CAC evidencing the completion of cybersecurity review and approval (if applicable) and approvals from its business regulators. In addition, the Draft Overseas Listing Administrative Provisions propose a parallel post-listing disclosure system where the domestic enterprise shall disclose to CSRC matters relating to follow-on offerings, material changes of business, material impact on a permit, change of control, change of listing plans or regulatory actions by any overseas securities regulator.
The Draft Overseas Listing Administrative Provisions also stipulate the following ‘red lines’ where overseas securities offering and listing of a domestic enterprise shall be prohibited: (1) specific prohibition imposed by national laws and regulations (such as prohibition on the financing of curriculum-based tutoring institutions by way of public listing); (2) a finding of threat or danger to national security as reviewed and determined by competent review authorities under the State Council; (3) existence of material ownership disputes over the equity, major assets or core technology, etc., of the issuer; (4) corruption, bribery, embezzlement, misappropriation of property or other criminal offences disruptive to the order of the socialist market economy committed in the past three years by the domestic enterprise or its controlling shareholders or actual controllers, or ongoing judicial investigation on the domestic enterprise or its controlling shareholders or actual controllers for suspicion of criminal offenses or major violations of laws and regulations; (5) administrative punishment for severe violations imposed on directors, supervisors or senior executives of the domestic enterprise in the past three years, or ongoing judicial investigation on such persons for suspicion of criminal offenses or major violations of laws and regulations; and (6) other circumstances as prescribed by the State Council.
While the Draft Overseas Listing Administrative Provisions and the Draft Overseas Listing Filing Measures provide long-anticipated guidance on the regulatory requirements and procedures on overseas issuance and listing of securities by domestic enterprises, there are quite a few ambiguities and practical questions, such as application of standards on filing requirements, implementation of a transitional period, treatment of ongoing listing applications, enforcement actions on cases with national security risks and domestic enterprises that fail to fulfil filing obligations, which remain to be answered in the final version of such provisions and measures and subsequent implementation rules and guidelines.
To echo the proposed changes in the Draft Overseas Listing Administrative Provisions and the Draft Overseas Listing Filing Measures, CSRC published the revised Provisions on Strengthening Confidentiality and Archives Administration of Overseas Securities Offering and Listing by Domestic Companies (Draft for Comments) (the Draft Amended Archives Rules) on 2 April 2022. Compared with the Provisions on Strengthening Confidentiality and Archives Administration for Overseas Securities Offering and Listing (Announcement No. 29 ) (the Current Archives Rules), the scope of the Draft Amended Archives Rules has been expanded to cover (1) domestic companies that propose to go public through indirect listing and (2) securities companies and securities service institutions. The Draft Amended Archives Rules require domestic companies seeking direct or indirect overseas securities offering and listing, as well as securities companies and securities service institutions providing securities services, to strictly comply with confidentiality and archives management requirements, establish a sound confidentiality and archives system, and take necessary measures to implement their confidentiality and archives management responsibilities. In the event that a domestic company needs to disclose or provide any materials that contain relevant state secrets and government work secrets to securities companies, accounting firms or other securities service providers and overseas regulators, such company should obtain prior approval and complete filing and other regulatory procedures. Intertwined with cybersecurity and data security laws and regulations promulgated and implemented in recent years, the Draft Amended Archives Rules require a domestic company to complete relevant procedures stipulated by applicable national regulations when it plans to publicly disclose or provide documents and materials that, if divulged, would jeopardise national security or the public interest.
The Draft Amended Archives Rules also establish a cross-border regulatory cooperation mechanism as prescribed in Article 177 of the Securities Law (which took effect on 1 March 2020) and strengthen cross-border regulatory cooperation under the principles of reciprocity and mutual benefit as prescribed in the Draft Overseas Listing Administrative Provisions. The overall direction of cross-border supervision of overseas listings is expected to change from a PRC-dominant approach under the Current Archives Rules to a cross-border regulatory cooperation mechanism. It is provided in the Current Archives Rules that overseas securities regulators and other relevant bodies may conduct an on-site inspection or an off-site inspection of companies that have listed (or intend to list) overseas, as well as securities companies and institutions providing services for the overseas issuance and listing of securities (including accounting firms). An on-site inspection had to be conducted at the designated site in the PRC, with prior approval from competent PRC authorities, and had to be carried out mainly by PRC regulators or had to have relied on the inspection results of PRC regulators. With respect to an off-site inspection, companies that have listed (or intend to list) overseas, securities companies and securities service providers (including accounting firms) had to obtain prior approval from competent PRC regulators if state secrets, archives (including working papers) administration and other matters otherwise required to be approved are involved. The Draft Amended Archives Rules no longer differentiate between on-site and off-site inspections but rather place them under unified regulation of a common cross-border cooperation mechanism.
Four months after the launch of the Draft Amended Archives Rules, PCAOB announced the SOP with CSRC and MOF in respect of cooperation on the oversight of PCAOB-registered public accounting firms based in mainland China and Hong Kong. This marks a significant step in addressing the decade-long audit oversight conflict between the SEC and PCAOB, on the one hand, and CSRC and MOF, on the other hand. It is provided under the construct of the Draft Amended Archives Rules that working papers produced in the PRC by securities companies and securities service institutions in connection with securities services provided for overseas issuance and listing should be stored in the PRC. In response to this provision and other similar rules in applicable laws, it is agreed in the SOP that PCAOB shall conduct on-site inspections and investigations at the offices of accounting firms PwC and KPMG in Hong Kong. On 15 December 2022, PCAOB announced that it had secured complete access to inspect and investigate firms in China for the first time ever, removing the risk that around 200 Chinese companies could be kicked off the US stock exchanges. However, PCAOB also stated on the same day that this is only the beginning of its work to inspect and investigate firms in China, not the end. PCAOB will be continuing to demand complete access in mainland China and Hong Kong in the future.
iii Amendments to the foreign investment Catalogue of Encouraged Industries
On 26 October 2022, NDRC and MOFCOM jointly issued the updated version of the Catalogue of Encouraged Industries, which came into effect on 1 January 2023, and contains a list applicable to the entire country, and another list applicable only to China’s central, western and north-eastern regions and Hainan province. Compared with the previous version in 2020, the number of industries in which foreign investment is encouraged has been expanded. The updated Catalogue of Encouraged Industries contains a total of 1,474 items, among which 519 items are in the national catalogue and 955 items are in the regional catalogue. These items align with China’s plans to attract foreign investments into high-tech manufacturing and production-oriented service industries, as well as regional advanced industries in the central, western and north-eastern regions. More than 80 per cent of the new additions and revisions of the nationwide list fall within the manufacturing sector, which supports and encourages foreign investment into high-end manufacturing, intelligent manufacturing, green manufacturing and relevant areas. The list applicable to central, western and north-eastern regions and Hainan province is more focused on labour-intensive industries and advanced and applied science industries, as well as the construction of supplementary facilities, and it is also noticeable that additions in relation to the tertiary sector have increased, encouraging foreign-invested businesses operating in those industries and sectors to move to those regions.
iv Second Draft Amendment of the Company Law
On 30 December 2022, the Standing Committee of NPC issued the second draft amendment of the Company Law (the Second Draft Amendment of the Company Law) for public comments. This was the second version of the draft revisions of the Company Law to be released in the past two years, making further amendments based on public comments collected to a previous draft released in 2021. To sum up, the approximately 70 substantive changes in the Second Draft Amendment of the Company Law are intended to reinforce shareholders’ obligations on capital contributions, optimise corporate structure and corporate governance (including those specifically in relation to listed companies), improve provisions in relation to directors’ liabilities, refine special provisions on state-invested enterprises and add provisions in relation to professional indemnity insurance for directors and mandatory deregistration of companies. Most of the revisions proposed under the Second Draft Amendment of the Company Law intend to refine the new mechanisms proposed in the first draft amendment issued by the Standing Committee of NPC on 24 December 2021. We shall wait to see to what extent such changes, subject to multiple rounds of review and revisions, will eventually be built into the final version of the Company Law.
v Changes in China’s antitrust regime
The amended AML, which came into effect on 1 August 2022, makes several major changes and additions and introduces new provisions to China’s antitrust regime, including:
- imposing harsher penalties for violations, including (1) increasing the maximum fine for failure to notify notifiable transactions to the AMR and imposing punitive fines for repetitive violations and (2) introducing penalties against individuals, including legal representatives and members of the management of a company. For example, the maximum fine is proposed to be significantly increased from 500,000 yuan to 5 million yuan for non-filing of an antitrust review that should have been submitted but did not raise competition concerns and 10 per cent of the prior year’s turnover of the subject company for non-filing of an antitrust review that should have been submitted and did in fact raise competition concerns;
- establishing safe harbour rules to exempt agreements concluded by companies with small market shares. Specifically, when a company that has entered into a monopoly agreement can prove that its market share in the relevant market is lower than the standard to be set by the enforcement agencies, the monopoly agreement may qualify for an exemption from antitrust scrutiny, absent evidence of competitive harm. It remains to be seen what the market share threshold for the safe harbour rule might be; and
- reforming the current merger control regime by introducing a ‘stop-the-clock’ mechanism, under which SAMR may suspend the running of the statutory review period in certain circumstances, including when (1) the business operators fail to submit documents and materials required for the statutory review, (2) new circumstances and facts emerge that have a significant impact on the examination, and (3) the restrictive conditions attached to the concentration of business operators need to be further evaluated.
On 27 June 2022, SAMR released six draft provisions to align with the changes in the amended AML and to increase coordination between general principles and specific implementation. The six provisions are:
- provisions on prohibition of abuse of intellectual property rights to exclude and restrict competition;
- provisions on prohibition of monopoly agreements;
- provisions on prohibition of abuse of dominant market position;
- provisions of the State Council on the standards for declaration of consolidation of undertakings;
- regulations on the review of concentration of business operators; and
- provisions on suppressing abuse of administrative power to exclude and restrict competition.
These provisions will assist in the implementation of the AML after they have passed and come into effect and will give more legal teeth to the law underpinning China’s anti-monopoly legislative framework. The new AML will significantly impact on large companies and, in particular but not exclusively, large technology and platform conglomerates.
On 22 November 2022, SAMR released the Draft Amendment to the Anti-Unfair Competition Law (Draft AUCL) for public opinion. The Draft AUCL aims to improve the anti-unfair competition rules for the digital economy, which prohibit operators from engaging in unfair competition by using data, algorithms and platform rules. Apart from traffic hijacking, improper interference and malicious incompatibility, which have been prohibited by the existing rules, the Draft AUCL further expands the scope of illegal practices such as malicious transactions; influencing user choices; misleading users by using keyword association, by setting false operation options or by other means; intercepting or blocking other operators’ pages without justified reasons; hindering the normal provision of online services or products; improper acquisition or use of commercial data; and big data-enabled price discrimination, etc. Given the complexity of determining unfair competition in the digital economy, certain factors will be considered to assess whether acts of unfair competition have been committed, including (1) the impact on the lawful rights and interests of consumers, other business operators and the public interest; (2) whether compulsion, coercion, fraud or other means are adopted; (3) whether usages of trade, business ethics and business morality are violated; (4) whether the principles of fairness, reasonableness and non-discrimination are violated; and (5) the impact on technological innovation, industry development and network ecology.
The Draft AUCL also reflects more stringent enforcement on commercial bribery. To be specific, the existing rule only prohibits business operators from providing bribes to any employee of the counterparty of a transaction, whereas the Draft AUCL includes the counterparty as a bribed party (also see Section II.iii, above). The Draft AUCL explicitly extends prohibition against ‘instigating others’ to engagement in bribery. The maximum amount of fines for providing bribes will be increased from 3 million yuan to 5 million yuan. Another highlight of the Draft AUCL is on aiding acts of confusion. Under the Draft AUCL, a business operator is prohibited from (1) selling confusing commodities or providing facilitative conditions such as the storage, transport, mail, printing, concealment or business premises for the commission of confusing acts; (2) using methods such as organising false transactions or fake appraisals to help other business operators conduct false or misleading commercial publicity; and (3) helping others to use rights holders’ commercial secrets in violation of confidentiality obligations or the rights holders’ demands for preserving commercial secrets. The Draft AUCL represents a significant revision to the existing rules and outlines detailed rules for violations while also enhancing the predictability of the system and the standardisation of law enforcement. Once adopted, it is expected to help regulate noticeable problems during the implementation process while defining new unfair competition behaviour to fill the legal gap and strengthen legal responsibilities.
The year 2022 was a volatile year that witnessed a notable decrease in private equity transactions in China. Many of the underlying challenges that beleaguered 2022, such as geopolitical risks, global rate hikes, sticky inflation, tight credit markets and the energy crisis, may linger long into 2023. Such unfavourable factors, together with silver linings such as a reset in valuations and lessened competition for deals, present dealmakers and investors with both risks and opportunities. Investors will be required to navigate the market more carefully and identify quality assets and value-creating opportunities as well as to develop competitive investment strategies and ensure good exits for existing portfolios in the context of any market disruption and its resulting business impacts.
Looking forward to 2023, we expect several key factors to impact on the level of dealmaking activities in China. With the end of the pandemic and the reopening of China in full swing, accompanied by Chinese authorities’ plans to expand domestic demand, promote consumption and rejuvenate the real estate sector, we expect to see a recovery in private equity investment as well as in overall economic activities.
The regulatory landscape is also a key factor that may impact on investment patterns. In addition to broadened market access and an improved foreign investment environment as a result of the FIL, the negative list management system, the Catalogue of Encouraged Industries and the launch of various free trade zones, foreign investors may find new opportunities in the reorganisation, consolidation and restructuring of SOEs, listed companies, financial institutions and top-notch start-ups and in broader and faster-growing industry sectors. On the other hand, increasing regulatory challenges both home and abroad in antitrust enforcement, anti-corruption practices, national security, data protection and cybersecurity may further complicate dealmaking, prompting private equity investors to make necessary adjustments to their China investment and exit strategies and devise more creative deal structures.
As part of its ongoing reform of the IPO regime, on 1 February 2023, CSRC released draft measures and regulations for the implementation of a registration-based IPO system for public comment. The implementation of these measures is expected to usher in a strong year for private equity-backed IPOs in China’s domestic stock markets.
Going-private deals likely will also pick up in 2023. Although the threat of delisting under the HFCAA has temporarily receded following the US–China audit deal, geopolitical risks and tightened regulatory scrutiny both home and abroad may continue to impede US listing activities by Chinese companies. On the other side of the Pacific, HKEX, with its listing regime for homecoming US-listed Chinese companies, biotech companies, SPACs and, more recently, specialist technology companies, may offer unique value propositions in a new era of China investing.