Red-chip listing is one of the important routes for Chinese enterprises to access offshore funds. Since the Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors (Circular 10) from the Ministry of Commerce of the People’s Republic of China (MOFCOM) and other five ministries and committees took effect in 2006, red-chip listing of private enterprises has been in a new regulatory era. According to Circular 10, examination and approvals are required from MOFCOM and the China Securities Regulatory Commission for domestic companies or individuals to establish offshore special-purpose vehicles (SPV) as offshore listing entities. Given that the approval procedure is tedious and the standards are ambiguous, no market precedent has been found to be fully compliant with the approval process under Circular 10.
As for the red-chip companies that have successfully listed overseas, foreign IPO attorneys need to rely on the legal opinions of domestic attorneys stating that “Circular 10 does not apply to red-chip restructuring of the company”. In other words, the domestic attorneys must reason out that the acquisition of a company holding domestic assets of a SPV is not tantamount to buying a “domestic company” as defined in Article 2 of Circular 10. In practice, the company holding such domestic assets will first be restructured into a Sino-foreign joint venture, which the SPV will acquire later. It is worth noting that this practice in whole may be subject to the provisions of Article 11 of Circular 10 on related-party M&A, which provides that a domestic company or individual is required to obtain approval from MOFCOM to establish an offshore SPV to acquire its affiliated domestic company. In practice, many cases skip the separate legal analysis on related-party M&A provision, to which the regulator tacitly consents.
However, in cases lately, we note that the regulator is beginning to inquire into whether the SPV’s acquisition of the Sino-foreign joint venture under the said structure falls within the scope of related-party M&A. It remains unclear if the regulator intends to tighten the policies for private enterprises seeking overseas IPOs through the related-party M&A provision. The author, however, recommends that enterprises planning red-chip listings should pay special attention to this trend in policies and give consideration to the following factors:
First, a domestic company shall plan strategically when converting the domestic company into a foreign JV. It shall choose a non-affiliated offshore investor to be the foreign shareholder of the JV, so that the restructuring will not be construed as related-party M&A from the beginning. In the meantime, the domestic company shall pay attention to the percentage of equity that the overseas shareholder acquires and the business rationale behind the purchase. In red-chip enterprises already listed on the Stock Exchange of Hong Kong through acquisitions of JVs since 2014, foreign investors typically hold 1%-10% of the stock, most commonly 5%. China Leon, Yadea Group Holdings, and China Partytime Culture are examples. Considering the current trend in policies, we recommend a foreign shareholding percentage of no lower than 10%, to avoid the regulator’s construing the acquisition to be a sham transaction to circumvent the regulation. The independence of foreign investors and the business rationale behind the shareholding percentage can be a strong argument to prevent the restructuring and acquisition to be regulated under Circular 10.
Second, the domestic company shall communicate with the regulatory authority in advance with respect to whether actual controllers’ acquisition of equity in the JV through the SPV is subject to the related-party M&A provisions. Although many enterprises in previous cases did not mention this issue in their prospectus and the regulatory authority tacitly consented to such an omission, given the current trend in the policies for the capital market, red-chip listing of a company may face a substantial hurdle once the regulatory authority begins to look over such acquisitions. From the policy perspective, domestic companies and their teams of advisers shall reserve enough time for adjustment of red-chip listing plans to cope properly with the inquiry of the regulatory authority. They may also design other structures, such as changing the nationality of the actual controllers, etc., to circumvent the rules on related-party M&A.
Third, attorneys and professional agencies serving domestic companies seeking red-chip listings shall deepen the understanding of related-party M&A. So far, the market still construes “affiliated domestic company” in the related-party M&A provisions at the level of ownership relation, that is, shareholders of a domestic company shall not incorporate an offshore special purpose vehicle to acquire domestic assets. Meanwhile there has been no analysis of an acquisition of a domestic company by its senior executives, such as directors and supervisors, as shareholders of an offshore SPV. If the regulatory authority expands the explanation of “related-party M&A”, the red-chip listing of a company may be subject to more stringent regulations. Companies seeking red-chip listings shall be careful that any affiliated individual is not suitable to be an ultimate shareholder of the JV. Meanwhile, when the listing entity issues shares to stockholders or executives of a domestic company, it should give special consideration to the time and means of such issuance to avoid the application of the related-party M&A provision.
To sum up, we suggest that enterprises either recently undergoing or contemplating red-chip listings pay special attention to this trend in policies and attach importance to the risks that related-party M&A provision in Circular 10 may bring to the overall structure of such entities. Enterprises with plans for red-chip listings in the future, especially, should fully evaluate their own basic conditions and make adjustments in advance in accordance with laws and regulations and policies, to pave the way for their red-chip-listing plan.
Jason Cheng is a senior partner, and Wang Yuhui is an associate at Dentons