We recently learned that the PRC State Administration of Foreign Exchange ("SAFE") has formulated internal implementation rules and guidelines (known as "Implementation Notice No. 106") clarifying SAFE's Notice No. 75 (the "Implementation Rules"). The Implementation Rules were promulgated on May 29, 2007 and local SAFE bureaus began applying the Implementation Rules in the second week of June 2007.
The Implementation Rules will have a profound impact on how cross-border VC/PE transactions are done. The Implementation Rules, among other matters:
· Introduce length of qualitative financial and operation requirements (3 years of financial information) for candidate onshore companies;
· Require SAFE registration of option plans;
· Require documentary evidence of source of foreign exchange in excess of US$50,000;
· Introduce qualitative guidelines for retroactive SAFE applications; and
· Clarify of the definition of PRC residency.
Pursuant to the Implementation Rules, when an offshore special purpose vehicle ("SPV") with PRC residents as shareholders either establishes an onshore subsidiary or engages in a cross-border M&A, a Ministry of Commerce ("MOC") approval letter for the round-trip investment and the MOC approval certificate will now be required in connection with the SAFE registration.
Furthermore, the offshore SPV now must have been in operation and in a similar line of business for at least 3 years prior to the application in order to qualify, and the shareholding structure and management team of the offshore SPV must mirror that of the shareholding of the PRC target company. It is unclear how the foregoing restriction will impact transactions involving internet and mobile companies where certain shareholding limitations are mandated by PRC law.
With respect to an SPV that has completed the round-trip investment (i.e. the onshore subsidiary has obtained its foreign exchange certificate) but has missed the March 31, 2006 registration deadline, the SPV may now submit a retroactive registration application, provided that there has been no payment of any funds by the onshore subsidiary to the SPV since April 21, 2005 in the form of a dividend, profit sharing payment, liquidation proceeds, capital reduction, or loan repayment. In the event such a payment has occurred, SAFE may impose penalties on the applicants and/or the onshore subsidiary for the evasion of foreign exchange laws and regulations. For SPVs which have not completed round-trip investment (the onshore subsidiary has not obtained a foreign exchange certificate) a retroactive registration may be completed by following the ordinary procedures and filing a new registration.
The enforcement of the Implementation Rules by various SAFE Bureaus is currently without uniformity. We expect enforcement to become consistent over time.
TIGHTENING OF POLICY
Along with the new M&A regulation promulgated by the MOC and other regulatory bodies in 2006, we believe the Implementation Rules reflect Chinese governmental policies intended to encourage Chinese emerging companies to list on domestic exchanges. We anticipate that there will be further rules and regulations coming from key regulatory bodies that will make investing in China from offshore funds increasingly difficult.
The new investment environment reflected by the Implementation Rules presents significant challenges for foreign investors seeking to structure VC/PE investments in China, and both companies and the investment community are strongly recommended to seek advice in advance from experienced counsel before structuring their VC/PE investments in China. If an error or omission is made at the outset, then it is highly likely that the financing transaction and/or the business structure will be in material non-compliance with PRC rules and regulations, to the significant detriment of the investors and the company.
REAL IMPACT ON DEALS
In the immediate term, we advise those companies and investors with transactions currently in process to execute and bring the transactions to closure as soon as possible. We also ask that investors seek the advice of experienced counsel prior to structuring their investments in China. We have already seen a number of transactions fail to obtain proper registrations from SAFE due to technical mistakes even when handled by reputable PRC counsel. We have also been presented with a growing number of transactions with improper or no SAFE registrations in place, a situation which effectively makes the corporate structure non-compliant unless significant remedial steps are taken immediately.
Long-time investors in the China market will recall periods of regulatory change during which deal flow slowed to a trickle if not to a virtual standstill. We believe that the Implementation Rules, together with the government's unwritten policy to encourage onshore listings, may herald another dry period for offshore investments into China and offshore listings of PRC companies.
SOLUTIONS
In the medium term, DLA has developed innovative structures that will still permit US dollar investments into Chinese companies and keep investor's preferential rights.
For the long-term, venture capital and private equity funds committed to investing and acquiring Chinese enterprises may be forced to establish Renminbi-denominated funds and to consider Chinese A share exits. DLA has begun to regularly advise on forming Renminbi-denominated funds, and we have already begun examining issues for foreign funds on potential China Renminbi exits in the A share market.
