ABA Section of Business Law
ABA Section of Business Law
Business Law Today
November/December 1998
Making deals in China
What you'll find; how it's done
By BENJAMIN M. VANDEGRIFTUntil recently Vandegrift was a partner in the Hong Kong office of Pillsbury Madison & Sutro. The author would like to express his sincere appreciation to Vincent Lo, Liu Yong Pin and Andrew Liu of the Hong Kong law firm of Gallant Ho & Co. for their assistance in preparing this article.
Economic reforms in China should pave the way for more deal-making. But will they?
The announcement, during the November 1997 meeting of the 15th Party Congress of the Chinese Communist Party, that many state-owned enterprises in the Peoples' Republic of China (PRC) would be "reformed" caused a surge of optimism that the deal flow out of China would dramatically increase. This optimism has not been tempered in the least by the Southeast Asian currency turmoil. Indeed, optimism probably grew as the PRC's government stepped forward to support the Hong Kong authorities in "maintaining the peg" of the Hong Kong dollar to the U.S. dollar.
The capital market in the PRC has made a remarkable transformation, probably as great as any nation in history, in the last 15 years. The central government's first tentative move into the international capital market took place only in 1981. Since then, China has seen the establishment of two national stock exchanges for debt and equity trading, as well as the initiation of trading in Chinese shares and debt in foreign markets around the world. Nevertheless, as recently as August 1997, the U.S. Foreign and Commercial Service in Beijing reported that the total amount of China-related equity accounted for a mere 12 percent of GDP, a small percentage by world standards.
Some experts have predicted that China's equity market will grow from about U.S. $200 billion today to $500 billion by the turn of the century. The sheer size of this market has given rise to the optimism mentioned above that deals will flow out of China to both Chinese and American law firms. Indeed, the central government seems to be fully in accord with this view. Activity in Shanghai and elsewhere in the PRC has given rise to a fair amount of concern among both the government and the private sector in Hong Kong that Hong Kong will lose its preeminence in the region as the place to raise capital.
It will be a few years at least before an issuer seeks to have equity or debt listed on, say, the NYSE before listing those securities on the Stock Exchange of Hong Kong (SEHK). For that reason a number of American firms with offices in Hong Kong have loosely affiliated those offices with local Hong Kong law firms that practice in the securities area. Each firm brings its own skills to the arrangement. Hong Kong lawyers are skilled in the process of getting a listing application through the SEHK and the Americans are skilled at dealing with (or avoiding) the U.S. Securities and Exchange Commission.
In 1990, China established the Shanghai Stock Exchange and then, in 1991, the Shenzhen exchange. Both exchanges were fully on line and the improved efficiencies offered by these two exchanges swiftly put an end to the "off-book" trading that had been common up until then. Shortly thereafter, the two markets were unified and further standardized through a sophisticated over-the-counter computer network called the National Securities Trading Automated Quotation System (STAQ). Through STAQ, the more than 5,000 brokers and dealers scattered across China are able to buy and sell both equity and debt securities almost the same way it is done on NASDAQ.
To be sure, there are some unusual complexities about buying and selling Chinese equity securities. The securities themselves are divided into a number of categories:
- A-shares: These issues are traded on the Shanghai and Shenzhen exchanges, and represent common stock ownership in the Chinese company that issued them. They are available exclusively to Chinese citizens (although not to residents of Hong Kong).
- B-shares: These securities have exactly the same beneficial ownership rights as do A shares but can be purchased (and held) only by holders of foreign passports (including by those who hold a Hong Kong passport). They are quoted in U.S. dollar amounts on both the Shanghai exchange and on the Shenzhen exchange. The separation of the A and B share markets reflects the central government's preoccupation with restricting foreign control of the state owned sector and its desire to prevent the outside manipulation of China's fledgling stock markets. Maintaining a distinct marketplace for foreigners so that they use their own currencies also helps prevent excessive sales of the Renminbi (RMB) that could, especially in view of recent events in the Southeast Asian currency markets, cause its devaluation.
- H-shares: These are shares issued by state-owned enterprises incorporated in mainland China and that are listed on the SEHK.
- "Red chip" shares: Similar to H-shares in that they are listed on the SEHK, these shares are issued by companies that are government controlled but that have been incorporated, usually in Hong Kong, rather than in China. The Hong Kong entity is usually created as a shell that is then capitalized through the offering and is able to purchase assets located on the mainland through what is known as an "asset injection."
- L and N-shares: Shares of companies incorporated in China that have chosen to list them on either the London or New York exchanges. Plans are under way to permit China-based companies to list on the Tokyo, Sydney, Kuala Lumpur and Singapore exchanges as well.
- Debt and other financial products: Chinese government treasury bonds and bills trade on the Shanghai exchange and both Shanghai and Shenzhen permit trading in corporate debt (including convertibles, repurchase agreements and futures) as well as in warrants and rights. The shares of a few investment funds, similar in structure to U.S. closed-end funds, are also traded.
Moreover, if assets of a domestic enterprise are to be transferred to a Chinese-funded company registered outside China — whether to a listed or nonlisted company — by means of acquisition, exchange of shares, allocation or otherwise, the enterprise or the overseas company's controlling shareholder in the PRC shall obtain the prior consent of the provincial government or ministerial department of the central government, and the matter has to be examined and approved by the State Council's Securities Commission. Needless to say, since the promulgation of the Red Chip Guidelines, the activities of asset injection by window companies have slowed considerably.
There are some additional shareholding restrictions of which any lawyer undertaking a capital-raising project should be aware. No individual, Chinese or foreigner, can purchase a majority stake in any listed company. Of the outstanding shares for any firm, only 20 percent can actually be traded in Shanghai or Shenzhen, of that A-shares and B-shares account for 18 and 2 percent, respectively. Of the remaining nontrading securities, national, provincial and local governments, other state-owned enterprises and domestic institutions hold 30 percent, 45 percent are owned by other SOEs and domestic institutions, and the issuer and its employees retains 5 percent. The ownership of the tradable shares is divided between Chinese investors who command roughly 80 percent of the market float, Chinese banks and brokerages that own 10 percent and foreigners who hold another 10 percent in foreign currency denominated B-shares.
The PRC's legal system is based on written statutes and not on common law judicial precedent. In that sense it is similar to civil law systems. Indeed, prior to 1979, there were only a few laws or statutes in the PRC in the conventional sense. Since 1979, the PRC has adopted many statutes and regulations governing all aspects of its legal system. In December 1993, the Standing Committee of the PRC National People's Congress promulgated the Company Law, that became effective on July 1, 1994. In August 1994, the State Council issued the PRC Special Regulations on the Overseas Offering and Listing of Shares by Joint Stock Limited Companies for the purpose of regulating joint stock limited companies that offer, sell and list their shares outside of the PRC.
Though the Company Law is expected, ultimately, to serve as the core of a body of regulatory measures that will impose a uniform standard of corporate behavior on companies and their directors and shareholders, to date only a limited portion of this body of regulatory measures has been adopted. Currently, the primary sources of shareholder rights are the issuer's articles of association, the Company Law, the special regulations and, on listing on the SEHK, the Rules Governing the Listing of Securities on the SEHK (the SEHK Rules). Among other things the SEHK Rules impose standards of conduct, fairness and disclosure on the issuer, the directors of the issuer and any controlling shareholder.
The articles of association — the PRC issuer's main governing document — will also contain certain provisions required under the PRC Company Law. Since the PRC Company Law provides only a sketchy outline of what is required in an issuer's articles of association, the special regulations provide that the State Council Securities Commission and other authorized departments of the central government may issue regulations mandating certain provisions in the articles of issuers listed overseas. In 1994, the State Council Securities Commission and the State Commission for Restructuring the Economic System jointly issued a regulation entitled Mandatory Provisions in Articles of Association of Companies Listed Overseas.
These regulations emphasize that issuers seeking to list shares overseas shall include the mandatory provisions in their articles and may not alter or delete their content without authorization from the Securities Commission.
Under the mandatory provisions, the shareholders of a PRC issuer shall have the right to receive dividends pro rata according to their shareholdings; to attend or to entrust a lawyer to attend shareholders' meetings and to vote at the meeting; to supervise and manage business operation of the company and to raise proposals or address inquiries accordingly, etc. The shareholders also enjoy some "catch all" rights as stipulated in laws, statutory regulations and the company's articles of association. Moreover, some recent PRC issuers have begun to incorporate, in their articles of association, nonmandatory provisions concerning rights of minority shareholders in relation to fraud or oppression.
Subsequently the SEHK added a chapter to its listing rules dealing expressly with PRC issuers. Like the mandatory provisions regulation, the new SEHK listing rules provide detailed requirements that a PRC issuer must include in its articles of association if it is to be listed on the SEHK.
Despite these "fiduciary-like" provisions contained in the SEHK rules and in the issuer's articles of association, every prospectus filed by a PRC issuer with the SEHK that the author reviewed carries language, usually in both the risk factor section and in the description of capital stock, that the legal framework to which the issuer is subject "may be" (read, "is") materially different from Hong Kong company law or state corporate statutes and judicial decisions in the United States, particularly with respect to the protection of minority shareholders. These disclosures note also that "the mechanisms for enforcement of rights under the corporate framework to which the issuer is subject" may also be "relatively undeveloped and untested" and that, in the PRC, shareholders do not have the right to sue a corporation or its directors and officers derivatively.
Perhaps more troubling are the disclosures relating to the enforcement of civil judgments. The PRC does not have treaties providing for the reciprocal recognition and enforcement of judgments of courts with the United States, the UK, Japan or most other OECD countries. Thus, recognition and enforcement in the PRC of judgments of a court in any of these jurisdictions (in relation to any matter not subject to a binding arbitration provision) may be very difficult. Most prospectuses also disclose a PRC lawyer's opinion that judgments under U.S. securities laws will probably not be enforceable in the PRC.
The articles of association of each PRC issuer provide that most disputes between holders of H shares and the issuer, its directors, supervisors, officers or holders of A shares, arising out of the articles of association or the PRC Company Law, are to be resolved through arbitration organizations in Hong Kong or the PRC, rather than in the courts. The PRC is a signatory to the United Nations Convention on the Recognition and Enforcement of Foreign Arbitration Awards. Because Hong Kong participates in the UN Convention by virtue of the United Kingdom being a signatory to the Convention, it was generally thought, and so disclosed prior to the handover of Hong Kong to the PRC on July 1, 1997, that an award by an arbitration organization in Hong Kong could generally be enforced in the PRC. Whether the same is still the case after the July 1997 handover is not known. Similar disclosures in registration statements filed subsequent to July 1, 1997 have simply not addressed the question.
Other unusual risk factors included in a PRC issuer prospectus address the problem of the very existence of an issuer in the PRC, noting the obvious that "the economy of the PRC differs from the economies of most countries belonging to the OECD in such respects as structure, government involvement, level of development, growth rate, capital reinvestment, allocation of resources, rate of inflation and balance of payments position." These prospectuses do point out that since 1978 the PRC "has been reforming and is expected to continue to reform, its economic systems" but that, nevertheless, "many of the reforms are unprecedented or experimental."
Perhaps the most interesting part of putting together one of these "China deals" is the restructuring of the company to shift "productive" assets away from nonproductive assets. As China "reforms" its state-owned industries and these now reformed companies turn to Western investment banks as well as accounting and law firms to raise capital, the due diligence teams sent to parse through the issuer's assets find that the company not only produces and sells coal, or petroleum products, or telecommunications, etc., but also has a myriad of other nonproductive assets that may include social service items for its employees such as clinics and other health care facilities, schools, recreational facilities such as bowling alleys, housing and security services and the like.
In addition, it turns out that many of these companies' sole "shareholder" is either the central or a provincial government or a quasi-government entity such as the China National Petrochemical Corp. (Sinopec).
Virtually every prospectus filed carries a disclosure section entitled "The Restructuring." Essentially, all this means is that rather than taking the preexisting company to the market or trying to sell off various of its nongermane or unproductive assets, a joint stock corporation is incorporated under the PRC Company Law with the preexisting company, described in the prospectus as the "predecessor" (which becomes, after the restructuring, the "parent") capitalizing the newly formed issuer ("Newco,") in exchange for domestic shares with the assets relating to the core business of the parent. It is the shares of the newly formed Newco that are then marketed to the public with the parent retaining typically 70 percent of the equity.
Of course, the relationship between the parent and Newco is not completely attenuated. Indeed, the two are inextricably linked together through decades of complex relationships. Not only that but the government entity that is still the sole shareholder of the parent, owns — because up until now everything in China is owned ultimately by the government — several other, competitive organizations.
An excellent example is described in the Beijing Yanhua Petrochemical Co. Ltd. (BYPC) prospectus under "Relationship with the Parent Company and Sinopec." Sinopec was established in 1983 as the controlling shareholder of a majority of the principal enterprises in the petrochemical industry within the PRC. It arranges annual allocations of crude oil and certain other raw materials and establishes production and sales targets and pricing levels for all petrochemical enterprises under its control. Sinopec's approval is required for major investments made by an entity under its control, including any investment made by the BYPC that exceeds RMB50 million or the foreign currency equivalent of U.S. $10 million. Even a cursory glance at this structure reveals serious conflict-of-interest potential.
To soften this conflict, Sinopec makes an "equal treatment undertaking" that, within the scope of the administration and coordination of Sinopec and in respect of all transactions between the parent and the issuer on the one hand and Sinopec and its other subsidiaries on the other, the parent and the issuer will be treated no less favorably than the other enterprise directly or indirectly under Sinopec's control. In addition, the articles of association of the BYPC provide that, in addition to any other obligation imposed by law, a controlling shareholder shall not exercise its voting rights in a manner prejudicial to the interests of the shareholders generally, including voting on certain enumerated matters of fundamental importance to shareholders. All prospectuses point out, however, that "there has not been any published report of judicial enforcement in the PRC of such provisions by minority shareholders."
Most China offerings in Hong Kong resemble each other in structure. Typically about 30 percent of the issuer's equity is sold in the offering. Seventy percent is held, as domestic shares, usually by the parent or by a number of entities within the PRC. The number of shares offered is usually quite large, often numbering as high, especially with the underwriter's "Green Shoe" or overallotment option, as one billion shares. The offering is usually divided into an international offering of American Depository Shares (ADS) and a Hong Kong offering of H shares although the total offering is registered with the SEC in the United States.
For example, in the China Southern Airlines Co. offering, the issuer registered 20,600,000 ADS "representing" 1,030,000,000 Ordinary H shares. Of the shares registered, 7,070,260 ADS were sold in the United States and Canada (the U.S. offering), 11,465,740 ADS were sold outside the United States, Canada and China and to "certain professional investors in Hong Kong" (the international offering), and an "offer for subscription" for 71,000,000 H shares in Hong Kong (the Hong Kong retail offering). Purchasers in the U.S. offering were given the option of receiving either ADS, evidenced in physical form by ADRs, or H shares, if they requested the latter.
PRC issuers are structured, legally, in much the same way that Western or Japanese companies are structured. Each issuer has shareholders, albeit with the various restrictions stated above. Each has a board of directors with both inside, executive directors and "outside" or unaffiliated directors. Some issuers have, in addition to boards of directors, something called a committee of supervisors, whose job it is to make sure the directors, the executive officers, and the controlling shareholder do not violate their obligations to the minority, public, shareholders.
Every China prospectus contains a section entitled "projections." This will no doubt give many U.S. securities lawyers a bad case of hives but, in the relatively nonlitigious atmosphere of Hong Kong and the PRC, this is standard stuff. Indeed, if there are enough "China offerings" it may lead some otherwise conservative U.S. securities lawyers to use the "bespeaks caution" doctrine in some IPO prospectuses in non-China offerings in the United States.
The section on projections states quite plainly that "prospective financial information for the year ending Dec. 31, 1997" is included "in accordance with customary practice in securities offering in Hong Kong." The prospectus also disclaims any intention to update the projections. (Such a disclaimer may simply not be effective under U.S. securities law.) In bold-faced type, the section goes on to warn of the potential that it "was not prepared with a view toward compliance with published guidelines of the U.S. SEC and the AICPA regarding forecasts or projections" but rather was prepared in accordance with local market practice. In the best "bespeaks caution" language, the section goes on to caution the investor against "undue reliance" on these inherently unreliable projections.
The projections themselves are quite specific. Revenues and net income are projected to be, at year-end 1997, to be "not less than" xxx RMB under both Hong Kong and U.S. GAAP. These numbers are also projected in terms of earnings per share. The section finishes with a list of assumptions on which it states the projections are based. These assumptions are relatively broad, i.e.; no major political changes in the PRC, operating income will rise by 44 percent, etc.
This brief article has attempted to set out the basic procedures for raising public capital for a PRC "Red Chip" company. Obviously, competent counsel from all three jurisdictions involved — the United States, Hong Kong and the PRC — need to be involved if the transaction is to be a success and not run afoul of the process in one or more of those jurisdictions.
Certainly, it is to be hoped that the process will become less complicated as the financial system in the PRC improves. Given the swirling Asian currency crises, it may be a good time to begin the simplification process.
At the National Peoples Congress meeting in Beijing last November, a number of proposals for modernizing the PRC financial situation were discussed in a more open forum than has been true in the past. PRC lawyers and those of us who practice on the Asian rim are awaiting the outcome of these discussions. The Asian financial crisis may have slowed things down a bit, but the future is still bright.
