OFFSHORE ACQUISITION & VIE STRUCTURE
At present, China governments put more and more off-limits on acquisition of domestic enterprise by foreign investor. Such kind of acquisition should comply with not only regulations regarding merger & acquisition, but also the laws and regulation regarding anti-monopoly and economic security review. Clearly, the aforesaid complicate examination and approval procedure increase uncertainty of the transaction. As such, more and more Chinese companies would like to take approach of offshore structure acquisition.
1. What is a typical structure of an offshore acquisition?
Under a typical structure of an offshore acquisition, PRC seller: 1) owns equity interest in a purely domestic limited liability company (“LLC”); 2) then sells equity interest in LLC to offshore special purpose vehicle ( “SPV” ), which was established by PRC seller; 3) then sells shares in offshore SPV to foreign buyer.
2. Why a foreign investor chooses offshore acquisition?
The offshore structure acquisition has the following advantages:
1) for the seller, the offshore acquisition helps them to receive payment offshore and achieve tax savings purpose, and there is no PRC government approval required ;and
2) for the buyer, they will have more flexibility in deciding structuring terms, including payment, and the offshore structure acquisition will also shorter completion time.
3. Has the offshore structure acquisition been affected by The Rules on Acquisition of Domestic Enterprise by Foreign Investor (M&A Rules), which took effect in September 8, 2006(“Effective Date”)? If yes, then how?
Article 11 of M&A Rules stipulates that if a PRC domestic company, enterprise or natural person intends to acquire an affiliated domestic company in the name of an overseas company lawfully established or controlled by it/him/her, it/he/she should report the same to the Ministry of Commerce (“MOFCOM”) for examination and approval; However, in practice, there is no precedents of MOFCOM approval for affiliated acquisition. That means, if PRC seller sells equity interest in LLC to offshore SPV(which was established or controlled by PRC seller) after Effective Date of M&A Rules, MOFCOM will not grant approval on such transaction and then the offshore structure acquisition would be broken down due to lack of MOFCOM approval.
4. Given M&A Rules has affected offshore structure acquisition, lawyers have developed new options to deal with off-limits put by Article 11 of M&A Rules?
Yes. In practice, in order to circumvent Article 11 of M&A Rules, lawyers and investor has developed four options to conduct offshore acquisition, which are:1) pre-Sep 2006 offshore structure acquisition; 2) VIE(“variable interest entity”) structure acquisition; 3) “convert LLC to FIE first” structure acquisition ; and 4) “creeping” acquisition. VIE structure acquisition is the most common structure adopted by Chinese company.
5. What are the normal steps for VIE structure acquisition?
VIE structure acquisition is commonly found in industries with foreign equity participation restrictions or investor qualification requirements. Normally, the steps for VIE acquisition include:
1) PRC founders set up LLC in the RPC in which PRC founders owns equity interest;
2) PRC founders establishes an offshore company(the so-called SPV);
3) This offshore company sets up a WFOE( Note: in order for the offshore company to set up a WFOE in China, PRC founders should carry out SAFE Notice 75 filing);
4) Forging investor invests in offshore company; and
5) WFOE controls and extracts profits from LLC(owned by PRC founders, as advised in Step 1) through a set of contractual agreements;
The following diagram shows process of a VIE structure acquisition:
6. What are the transaction documents required and what can a lawyer do for an offshore acquisition?
An offshore acquisition should at least include the following document: 1) Series A Preferred Share Purchase Agreement ("SPA"); 2) Shareholders Agreement ("SHA"); 3) Amended and Restated Memorandum and Articles of Association ("Amended M& AA); 4) Restructuring documents (which normally includes service provider agreement, intellectual property right license agreement, equity pledge agreement, and call option agreement and so on.); and 5) the documents regarding employee stock option plan.
SPA is used by a foreign investor to acquire PRC founder's equity interest in the SPV under which the foreign investor will enjoy preferential rights, such as the right of information, liquation preference, the right of anti-dilution, the protective provision, right of redemption, right of drag-along, co-sale right and dividends payment. If a lawyer represents PRC founder or the target company, he should know how to protect the PRC founders or target company under the aforesaid preferential rights. Also, he should be very careful in dealing with the warranties and representations made by his client and make extreme sure the warranties and representations are true, complete and accurate.
If a lawyer act on behalf of the foreign investor, he should make sure that the conditions to the closing as stipulated in SPA should be satisfied prior to closing and the derivatives evidencing the satisfaction of the conditions be delivered to the foreign investor.
SHA give the foreign investor broad-range rights, such as registration rights, right of first refusal etc., to assure that the interest of the foreign investor has been fully protected.
M&AA is a requisite document which states the basic information of the company, such as the company's name, registered address, highest organ of power, composition of highest organ of power, meeting, share capital and so on. With the equity transfer in the company, M&AA should be amended to reflect the capital increase of the company due to investment by the foreign investor, as well as the special rights for the foreign investor which have been agreed in SPA and SHA.
Among the restructuring documents, service provider agreement or intellectual property right license agreement will be used by WFOE to extract profit from LLC under which LLC should pay service fee or license fee to WFOE. Equity pledge agreement will be used by WFOE to control LLC and guarantee the payment of the service fee or license fee by LLC under service provider agreement or intellectual property right license agreement. Under call option agreement, PRC founder is required to grant WFOE (or one or more of the persons designated by WFOE) an exclusive option to purchase all or part of the shares of PRC founder in LLC.
As to a lawyer's work on VIE structure acquisition, he/she can help their client to conduct due diligence investigation, design and establish VIE structure (including, but not limited to, establishing a special purpose vehicle, forming the WFOE in China, advising particular legal issues regarding the VIE structure, etc.), represent the client in negotiations with the VC funds on Shareholder Agreements and Series A Preferred Share Purchase Agreement(including, but not limited to, reviewing the term sheet and negotiating on the clauses regarding the right of information, liquation preference, the right of anti-dilution, protective provisions, the right of redemption, the right of drag-along, co-sale right, and dividends payment, etc. ), assist the client in fulfilling closing duties, draft restructuring agreements (including, but not limited to, service provider agreement, intellectual property license agreement, equity interest pledge contract, call option agreement, etc), help the clients to carry out SAFE Circular 75 Registration (including, but not limited to, preparing the relevant documentation and advising the relevant issues), draft and revise the employee stock option plan, help the client to draft the resolutions of board of directors regarding the VIE acquisition, help the client to do post-closing work, etc.
7. How does SAFE Circular 75 affect VIE structure acquisition?
In 2006, China government promulgated SAFE Circular 75 which is intended to regulate the round-trip investment by PRC natural person or company. Under SAFE Circular 75, when a PRC founder intends to establish offshore company and then this offshore company set up a WFOE in China, the PRC founder should file this round-trip investment with SAFE.
As VIE structure acquisition involve round-trip investment (namely, PRC founder will set up SPV, and the SPV establish a SPV), SAFE Circular 75 filing become an issue. Under VIE structure acquisition, two SAFE filing are required under SAFE 75 regime. When the SPV, which is established by the PRC founder, set up a WFOE, PRC founder need to carry out initial SAFE 75 registration; when the foreign investor acquire PRC founder's share in the SPV, and therefore make investment in the SPV, and SPV then increase capital of WFOE, PRC founder also need to conduct SAFE 75 alteration registration.
China government control VIE acquisition by restraining or loosening up SAFE Circular 75 registration process. In Shanghai and Beijing, local SAFE usually take stricter attitude than other regions towards application of SAFE 75 registration. They typically have some internal rules to deal with such kind of application. For example, in late 2011, Beijing SAFE did not accept SAFE 75 registration application if PRC founder reorganize SPV by the way of share repurchasing.
In May 2011, China government promulgated SAFE Circular 19 providing more detailed specifics for round-trip investment filing, which, at a certain point, make registration process more clearly.
Q: What are the key facts and disputes of the related case?
A: In 2010, the Supreme People’s Court initiated the retrial procedure to hear the dispute
among Mianyang Hongri Industry Co., Ltd., Jiang Yang and Mianyang Gaoxin District
Technology Innovation Industry Co., Ltd. over the validity of a resolution adopted by the
shareholders’ meeting with concerns the company’s capital increase ((2010) Min Ti Zi No. 48, the “Supreme Court Case”).
In that case, Mianyang Gaoxin District Technology Innovation Industry Co., Ltd. (“Technology Innovation Co.”) failed to offer its original shareholders the option to exercise their
preemptive right to subscribe to the increased amount of capital; instead, the shareholders’
meeting directly resolved to let third parties subscribe to the entire amount of new capital by following the capital majority rule, thus infringed the original shareholders’ priority to
contribute to the new capital in proportion to their capital contributions.
The disputes focused on: (i) whether the Shareholder Resolution on the increased capital to
Be subscribed by the third party and the Agreement of Capital Subscription are valid; (ii)
Whether could the infringed original shareholders exercise the preemptive rights?
The court finally held that the portion of the new capital on which the original shareholders could have exercised their preemptive right shall be null and void on the ground of the infringement, whereas the Agreement on Subscription with the third party was regarded as effective.
Furthermore the court considered that the infringed original shareholders did not exercise their
Preemptive rights, and therefore denied their requirement of exercising preemptive right.
Q: What are the implications of this case?
A: The Supreme Court Case is a rather typical dispute in regard to the infringement of
shareholders’ preemptive right in limited liability companies during the process of capital
increase. This case has fully illustrated that shareholders’ preemptive right is protected by law, and that such right cannot be deprived of or restricted, albeit the capital majority rule abused by the company.
Nonetheless the upholding of the Agreement of Subscription reflects the legal principle that
Flaws of internal procedures cannot be used against the third party of bone fide.
The most import implication of this case is regards the exercise period of preemptive right.
The opinion of the Supreme Court serves guidance where there lacks clear regulation on this point. In this case the Supreme Court considered that the original shareholders’ preemptive right to subscribe increased capital of a Company is a kind of right of formation, and it should be exercised within a reasonable time limit to safeguard security and stability of economic order.