TopicsinChineseLaw AN O'MELVENY & MYERS LLP RESEARCH REPORT January 2008 China's Regulation of "Round Trip Investments" * by Howard Chao and Kaichen Xu ** During the past couple of years, China has been tightening its regulation of so-called "round trip investments" -- transactions where Chinese domestic companies were reorganized into an offshore holding company structure and their ownership moved to the offshore level. In a typical "round trip investment", a Chinese resident will establish or control an offshore holding company, and use this offshore company to control a Chinese company by either direct acquisition or captive contractual arrangement. This type of restructuring has often been used in the past 10 years in order to facilitate private equity investments in Chinese companies and to prepare companies for offshore listings in Hong Kong, the US or elsewhere. They were called "round trip investments" because the Chinese shareholder ended up receiving shares in the offshore holding company in order to indirectly own shares in his original domestic target company, which became a subsidiary. (See Figure 1 for the structures before and after "the round trip investment".) Traditionally it has been important for a Chinese company seeking international financing, whether in a PE investment or IPO, be structured as an offshore holding company in a common law jurisdiction like the Cayman Islands or Hong Kong. This is because the documentation and legal regime in common law jurisdictions, including preferred share provisions, shareholder agreements, and corporate governance, are more familiar to international investors. Doing all of this at the domestic Chinese company level was less attractive because of the less developed state of Chinese law. The Chinese government over time has become increasingly uncomfortable with round trip investment structures. China would prefer for the parent companies of Chinese companies to be Chinese so as to be able to monitor their shareholdings, control their foreign currency flows, and continue to tax them. China is ramping up its domestic capital markets and encouraging Chinese companies to list onshore rather than offshore. China wishes to develop its domestic financial services industry and related legal infrastructure. SAFE Starts to Regulate Round Trips The first Chinese agency to regulate round trip investments was State Administration of Foreign Exchange (SAFE). After some early regulatory missteps, in October 2005 SAFE issued * A shorter version of this article appears in this month's World Financier magazine. ** Howard Chao is the Partner in Charge of O'Melveny & Myers' Asia Practice. Kaichen Xu is an associate in the Shanghai office.
2 Circular No. 75 (Circular 75) to regulate round trip investments. Circular 75 requires Chinese residents to register with the local SAFE branch before establishing or controlling any offshore special purpose company with assets or equity in a Chinese company for the purpose of an equity financing. Failure to comply with Circular 75 can result in the offshore parent company's Chinese subsidiary being prohibited from distributing profits out of China, as well as liability under Chinese laws for violation of the relevant foreign exchange rules. The New M&A Regulations On September 8, 2006 China implemented amended regulations on merger and acquisitions by foreign investors (the M&A Regulations) which put a further brake on round trip investments. Under the M&A Regulations, central government approvals were for the first time required for all round trip investments through acquisition of the domestic target company by the offshore holding company, indicating a higher level of scrutiny. When the M&A regulations were enacted, many were concerned about whether this new rule would stop the flow of new PE backed companies and IPO candidates. It all hinged on how liberal the central government would be in approving round trip investments. Well, it has been more than one year, and the results are in. There have been virtually no approvals for restructurings of Chinese companies into offshore holding companies. This has put a stop to most organizations of Chinese companies into offshore holding company structures, reducing the future pipeline of deals. The Other Shoe Drops: Circular 106 After September 8, 2006, round trip investments via captive contractual arrangements remained a possibility, provided that the Chinese residents complete Circular 75 registration of such round trip investments. However, in May 2007, SAFE issued Circular No. 106 (Circular 106) as guidance for the implementation of Circular 75. Circular 106 sets forth more detailed procedures and stringent requirements for Circular 75 registrations of round trip investments. The highlights of Circular 106 include: SAFE now requires the domestic target company in a round trip investment to have 3 year operating history Circular 106 requires the Chinese resident to submit, among other things, a description of the 3-year financial performance of the domestic target company in the round trip investment in connection with Circular 75 registration. Both Beijing and Shanghai SAFE branches have interpreted this requirement as requiring the domestic target company in the round trip investment to have 3 year operating history. Of course, many Chinese companies seeking PE investment do not have 3-year operating history. "Greenfield" investments by Chinese residents are also subject to Circular 75 registration As noted above, Circular 75 was promulgated only to regulate round trip investments in which Chinese residents establish or control an offshore special purpose company to acquire their existing assets or equity in a Chinese company. Circular 106 has expanded the definition of "round trip investment" by requiring Circular 75 registration of "greenfield" investments by Chinese residents in offshore companies in which no pre-existing domestic company or asset is involved. Before an offshore holding company established or controlled by a Chinese resident can make a "greenfield" investment into China, the Chinese resident must make Circular 75 registration and the offshore company must have 2-year operating history (which may be shortened to 1 year for R&D companies).
Figure 1. BEFORE AFTER (A) "Round trip investment" through direct acquisition (B) "Round trip investment" through captive contractual arrangement 3 Therefore, after Circular 106, any onshore investment by an offshore company which is established or controlled by a Chinese resident is subject to Circular 75 registration. This again imposes a very difficult condition on establishing an offshore holding company structure. Who is a Chinese resident? Circular 75 originally defined the term "Chinese resident" to include (A)
4 Chinese resident legal persons, which are entities established in China and (B) Chinese resident natural persons, which are natural persons (i) holding Chinese passports or resident cards or (ii) natural persons habitually residing in China for economic reasons. In practice, local SAFE branches often reject applications for Circular 75 registration by foreigners and sometimes even Chinese nationals with foreign permanent resident status. Circular 106 now clarifies that a foreigner is a Chinese resident subject to Circular 75 registration, if he or she: 1. has permanent residence in China; 2. owns onshore assets or interest in the Chinese company; or 3. beneficially owns offshore asset or interest converted from his or her assets or interest in the Chinese company. Thus, merely changing the nationality of a founder will not relieve such founder from the requirement of Circular 75 registration. In short, Circular 106 significantly tightens the regulatory environment for offshore restructuring in preparation for a PE investment. Even if an applicant can meet the stringent standards under Circular 106, the process of making Circular 75 registrations will certainly become more burdensome, uncertain, timeconsuming and costly. Indeed, because of these difficulties, specialized agents dealing with Circular registrations have become common. Impact on Dealflow How does all of this square with the fact that 2007 has been a bumper year for offshore IPOs of Chinese companies? In 2006 there were only 9 US IPOs of Chinese companies, whereas in 2007 there were 30. Similarly, in Hong Kong in 2006 there were 21 Chinese IPOs (excluding 23 H- Share listings), compared with 57 in 2007 (excluding 8 H-Share listings). And it is clear that the PE deal market for China remains very active, with many deals closed in 2007. Does this mean that the M&A Regulations and Circular 105 have had little impact on dealflow? Unfortunately not. It just means that the financing deals getting done today are in general for companies that were restructured prior to September 8, 2006. For example, at O'Melveny even with our large China PE dealflow, we have seen relatively few Series A financings in 2007 in China, and our deals in 2007 have tended to be later stage. All of the China IPOs we did in 2007 were also for companies that had been structured prior to September 8, 2006. Does this mean that the days of offshore financings and listings of Chinese companies are numbered? Not necessarily. In the short run, the pipeline still looks very strong. The number of later stage financing deals and offshore Chinese IPOs is still very high. We expect a strong first half of Chinese IPOs in 2008. Eventually we suspect that the Chinese government will need to start permitting round trip investments again. This would be in part due to political considerations - it is important to allow Hong Kong to continue to function as an international financial center for China. China cannot permit the flow of China listings in Hong Kong to run dry. Indeed, there are rumors that China's State Council, the equivalent of China's cabinet, will be issuing guidance on when Central Government approvals should be granted for round trip investments. It appears that some number of offshore holding company structures may again be approved. It may well be however
that a more restrictive regime will be put in place, where approval by the Chinese Central Government will be required of the offshore listings resulting from round trip investments completed after September 8, 2006 The Trend towards Onshore Deals But we should not be too sanguine about where this is all headed. The overall trend in China is in favor of moving transactions onshore. China has a tremendous amount of domestic liquidity seeking investments opportunities, preferably close to home. By offering more investment opportunities to Chinese domestic investors, the Chinese government can soak up domestic liquidity, and at the same time avoid too much foreign currency entering China, which is undesirable because it adds pressure to appreciate the RMB. And even if China needs to feed deals to Hong Kong, it could do so through additional H-Share offerings. H-share companies are share companies incorporated in China (without an offshore holding company) who do an offshore listing in Hong Kong. H-Share offerings are commonly used for state owned enterprise privatizations, but it is possible that China might turn to them as a model for future offshore private company listings, rather than offshore holding companies. Several private companies have already done H-share listings in Hong Kong. 5 Thus, in the long run, no matter how these regulatory issues evolve, it seems likely that the preponderance of China's financing activities for Chinese companies will move into China. That is where the largest pool of capital interested in Chinese companies are located, and this furthers the development of China's domestic financial services industry.
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