In This Issue
A number of acquisition loan arrangements have already been inked since the China Bank Regulatory Commission (“CBRC”) issued new guidelines (the “Guidelines”) on December 6, 2008 allowing commercial banks to provide loans to domestic enterprises conducting acquisitions within China and abroad.
In this legal update, we report on new merger and acquisition (“M&A”) lending activity, describe the substance of the new Guidelines and what changes they bring, and offer an outlook on the effects the Guidelines will have.
Two banks in China are reported to have taken advantage of the new Guidelines already, and another two are in negotiations to do so.
Most recently, on January 20, 2009, the China Development Bank signed a contract for a CNY 1.63 billion (USD 240 million) acquisition loan to the CITIC Guo’an Group. State media reported that this is the first acquisition loan since the Guidelines were promulgated. CITIC Guo’an, a subsidiary of the CITIC Group that invests in the information industry, natural resources development, and real estate development, would use the loan to increase its shareholding stake in the Baiyin Group, a non-ferrous metal processing company in northwest China.
The Industrial and Commercial Bank of China (“ICBC”) has been actively signing agreements establishing cooperative arrangements and lines of credit for M&A lending. On January 22, 2009, ICBC’s Guangdong branch signed a strategic cooperation agreement with China’s Southern United Assets and Equity Exchange (“CSUAEE”) whereby ICBC would extend a CNY 20 billion line of credit for future M&A transactions by local companies. ICBC claims that this is China’s largest-ever credit line for enterprise M&A. The loans will be extended to enterprises focusing on infrastructure construction, environmental protection, and high technology. On January 16, 2009, ICBC’s Shenzhen branch signed a strategic cooperation agreement with China Hi-Tech Property Exchange and Shenzhen Assets & Equity Exchange. The agreement would provide a CNY 10 billion line of credit to support the M&A transactions of local Shenzhen enterprises. On January 6, 2009, ICBC signed a cooperation framework agreement on M&A loans with Beijing Capital Co., Ltd., a Chinese company listed on the Shanghai Stock Exchange, engaging in infrastructure investment and operation management (particularly with respect to urban water supply and sewage disposal), and the China Beijing Equity Exchange. ICBC also granted a CNY 10 billion credit line for enterprise M&A transactions on December 25, 2008, in partnership with the Bank of Shanghai and the Shanghai United Assets and Equity Exchange. Under this latter arrangement, the Shanghai United Assets and Equity Exchange will be responsible for recommending well-performing, non-real estate projects to ICBC and the Bank of Shanghai to be the subject of acquisition loans.
China Construction Bank (“CCB”), like ICBC one of China’s “Big Four” state-owned commercial banks, is reportedly in talks with Baosteel Group Corp. Ltd. (“Baosteel”), China’s largest steelmaker, about making acquisition loans available to Baosteel. The Bank of Communications is also reportedly negotiating acquisition loans with steel manufacturing and shipbuilding companies.
What are the new Guidelines?
The Guidelines are essentially risk management guidelines that permit commercial banks to make M&A loans, reversing a previous policy prohibiting such loans, and that set parameters for such loans. As the requirements described below make clear, the Guidelines establish a clear principle that management of M&A loans by commercial banks in China must be stronger than that for other loans.
Generally speaking, prior to issuance of the Guidelines, M&A loans were prohibited by the General Rules on Lending (“General Rules”) issued in 1996 by the People’s Bank of China. Exceptions were limited to specifically approved M&A loans extended to state-owned enterprises (“SOEs”) for policy-driven purposes, such as M&A loans provided by ICBC to PetroChina and other large SOEs with special approval from the State Council for each loan. Although various approaches have been used by enterprises to obtain loans from banks in order to facilitate their merger transactions, direct loans for M&A were always treated as illegal.
Things began to change when the State Council stated its intention to stimulate the domestic economy by issuing statements known as the Ten measures to stimulate the economy (the “Ten Measures”) and the Nine financial measures (the “Nine Measures”) in December 2008. The Ten Measures are designed to increase investment in China by addressing goals such as improving infrastructure and enhancing financial support for economic growth. One of the goals of the Nine Measures is to boost new financing channels, including loans for mergers and acquisitions, real estate investment trusts, private equity funds, and private lending. The Guidelines, issued one week after the Nine Measures, are the embodiment of this goal with respect to M&A, effectively lifting the ban on M&A loans.
Qualifying banks must meet specified risk management requirements and capital adequacy tests on an ongoing basis in order to extend M&A loans. The key requirements and tests include having strong risk management and effective internal control systems, a loan loss reserve adequacy rate of no less than 100%, a capital adequacy rate of no less than 10%, a general reserve balance of no less than 1% of the loan balance for the same period, and established M&A risk assessment and due diligence teams.
Who can borrow?
Qualifying M&A loans can only be extended to domestic enterprises bearing industry and strategic relevance to the target of the acquisition. Although the term “domestic enterprises” is not defined in the Guidelines, we understand it to include FIEs that are incorporated in China under PRC law, such as joint ventures and wholly foreign-owned enterprises (“WFOEs”), but not foreign investors themselves.
An M&A loan must be extended in connection with acquisitions of new or existing equity interests, purchase of assets, or the undertaking of liabilities resulting in the merger with or the obtaining of de facto control over an already established and operating target enterprise. The Guidelines specifically allow for the M&A transactions to be carried out by special purpose vehicles (“SPVs”); that is, by means of a wholly-owned or controlled subsidiary enterprise that has been established especially by the acquiring party and that conducts no other business activities.
Notably, the Several opinions of the General Office of the State Council on providing financial support for economic development,issued by the State Council on December 13, 2008, refers to the possibility of M&A lending to offshore companies, which may portend a further relaxation of lending rules in the future.
The “strategic relevance” requirements
The Guidelines contain, in Article 22(3), requirements that the borrower/acquiring party and the target enterprise have a relatively high degree of strategic relevance.
How will the loans be structured?
The Guidelines make it clear that M&A loans will be treated as a special form of financing, subject to special financing terms, stringent risk analysis, and more in-depth due diligence.
The key terms of an M&A loan contemplated by the Guidelines include:
As for general risk management, a lender must comply with the following requirements:
As for due diligence, the lender is required to undergo a stringent risk analysis for each M&A loan transaction; the analysis must include examination of strategic risk, legal and compliance risk, integration risk, operation and finance risk, and government approval risk. The Guidelines highlight points of analysis for each such type of risk. In addition, the CBRC has said that where the M&A loans concern cross-border transactions, the lender must evaluate country risk, foreign exchange risk, and transit-of-capital risk.
The Guidelines represent a significant step away from the prohibition of acquisition finance in China that was previously embodied in the General Rules. Clearly, Chinese policy has moved in favor of strengthening support for M&A lending by commercial banks, including outbound investment. The Guidelines emphasize extensive risk assessment and dictate certain loan terms, but ultimately increase financing options—a welcome development amidst the current economic downturn. The CBRC has stated that it will closely track the M&A lending business and continually improve the supervisory rules and procedures in order to promote the healthy development of M&A lending.
The Guidelines are not expected to create an immediate boom in M&A lending, but they have generated much market interest by providing a regulatory framework for M&A lending. Banks and investors will continue to watch developments in this area with keen interest.
With more than 150 M&A attorneys handling deals from 17 international offices, Morrison & Foerster has one of the largest and most robust M&A practices globally. In the last three years alone, the firm has handled approximately 400 M&A deals valued at more than $200 billion. Morrison & Foerster is known for assembling the optimal team of resources from across the firm to tackle its clients’ legal challenges, bringing to all transactions the strength and resources of a large global law firm.
Ray Liu, a paralegal in the Hong Kong Office assisted with this article.