Faced with continuing pressure on renminbi depreciation and excessive capital outflow, China has been taking various measures to tighten its control on capital outflow since the end of 2016. These measures, which include increased regulatory scrutiny of outbound M&A deals and significant foreign exchange transactions, create significant uncertainties for Chinese outbound investments going forward. In this bulletin, we summarise these regulatory developments and explore the implications for China outbound transactions.
China's outbound investment surged significantly in 2016 reaching a record high of USD170.1 billion according to the Ministry of Commerce of China ("MOFCOM"). For the first time, it has overtaken total inbound investment which was valued at USD126 billion in 2016. Meanwhile, China's foreign exchange reserves have experienced a rapid drop since the second half of 2016, with an average USD52 billion monthly drop in the third quarter of 2016. In January 2017, China’s foreign exchange reserves dipped below USD3 trillion for the first time in five years. The surge in outbound investments and other unusual capital outflow by Chinese companies are believed to be among the causes contributing to the drop.
2. Increased regulatory scrutiny
So far, no formal, unified legislation has been issued to control capital outflow. However, since the end of 2016, regulators including the National Development and Reform Commission ("NDRC"), MOFCOM, the People's Bank of China ("PBOC") and the State Administration of Foreign Exchange ("SAFE") have taken various measures, either publicly or through "window guidance", to increase regulatory scrutiny on outbound M&A transactions and to tighten control on capital outflow.
Joint statements by four departments
At a press conference held on 6 December 2016, leading officials from NDRC, MOFCOM, PBOC and SAFE stated that China will continue to push forward reforms to streamline the administration of outbound investments. Authentic and compliant outbound investments by capable and qualified Chinese enterprises will be supported. However, the officials also noted that the government is paying close attention to potential risks associated with the following types of outbound investments:
irrational outbound investments in sectors such as real estate, hotels, cinemas, entertainment and sports clubs;
large outbound investments outside the Chinese investors' main line of business;
outbound investments by limited partnerships;
outbound investments by the so-called "small parent, large subsidiary", i.e., the outbound investment amount is much larger than the registered capital of the Chinese parent company; and
outbound investments by newly established companies with no substantive business for the purpose of quick investment.
The officials urged Chinese investors to take a cautious and prudent approach when making decisions to invest in the above areas.
NDRC's beefed up information reporting of outbound acquisition and bidding projects
On 5 December 2016, NDRC announced a modification to the "project information reporting form" required for outbound acquisitions and bidding projects.
Before the modification, if an outbound investment is US$300 million or more and is carried out through a competitive bidding or acquisition process, the Chinese investor was only required to submit a "project information reporting form" (along with the letter of intent and internal approval documents) to the NDRC before proceeding to execute a binding agreement, make a binding offer or submit formal bidding documents.
Following the modification, the Chinese investor must also (i) disclose additional information about its main line of business, date and place of incorporation, return on equity ratio, etc.; and (ii) submit the following additional documents:
the business license of the Chinese investor;
the most recent audited financial statements of the Chinese investor; and
the due diligence report for the outbound investment.
MOFCOM's upgraded online system to strengthen authenticity examination
On 2 December 2016, MOFCOM upgraded its online filing system for outbound investments. According to a briefing notice on this upgrade issued by the Department of Outward Investment and Economic Cooperation of MOFCOM, its purpose is to strengthen the examination of the authenticity of outbound investments.
Before the upgrade, a Chinese investor was only required to submit an online application form for a MOFCOM filing of its outbound investment; MOFCOM would decide whether or not to file an outbound investment within 3 working days after it had accepted an application.
After the upgrade, in addition to submitting the previously required documents, a Chinese investor must also submit the following documents:
the articles of association (or contract or agreement) relating to the outbound M&A target or the overseas company to be established;
the board resolutions or capital contribution resolutions of the Chinese investor;
the most recent audited financial statements of the Chinese investor;
a description of work carried out in preparation of the investment (including a due diligence report, feasibility study report, explanation of the source of funding and an assessment of the investment environment);
a standard form undertaking on the authenticity of the outbound investment which must be signed by all decision makers for such investment; and
an online standard form on preparations for an outbound M&A, if the outbound investment is an M&A transaction.
According to the briefing notice, MOFCOM will only formally accept an application for filing or verification of an outbound investment after it has completed the authenticity examination of the investment. This will add uncertainties to, and potentially prolong, the filing process.
"Window guidance" and bank practice
Although no formal regulations have been issued, it has been reported that in November 2016, SAFE and PBOC, the two monetary regulators in China, issued "window guidance" to banks at two briefing meetings aimed at tightening control on capital outflow. According to an unofficial document reportedly based on the minutes of these briefing meetings, banks are required to implement the following measures:
Any single foreign exchange transaction under the capital account (including not only fund remittance for outbound transactions but also remittance of dividends or equity transfer proceeds from China) of USD5 million (or its equivalent) or more must be reported by the bank to SAFE or PBOC to check its authenticity and compliance.
Any outbound investment involving outward remittance of USD50 million (or its equivalent) or more must be reported to SAFE or PBOC to check its authenticity and compliance, which would generally include interviews conducted by SAFE or PBOC with the Chinese investor.
Enterprises are not allowed to evade the scrutiny of SAFE or PBOC by splitting a large outward remittance into smaller remittances.
Outward remittance of funds relating to specific types of outbound investments (as noted in the joint statements by the four departments) and other "unusual" investments (such as outbound investments by companies that have high asset-liability ratio and low return-on-equity) will, in principle, be prohibited unless otherwise approved by the relevant authorities.
It is understood that since November 2016 most banks are following PBOC's and SAFE's "window guidance" and taking extra caution when handling outward capital remittances. As no official regulations or guidance have been issued, in many cases banks have to turn to local PBOC or SAFE for endorsement or opinion, which may cause considerable uncertainty and delay to transactions.
3. Implications for China outbound transactions
It is unknown at this stage whether and when new legislation will be issued to formalize the new measures to control capital outflow. Some commentators suspect that the tightened controls will remain in effect to stabilize capital outflow until the third quarter of this year when the 19th National Congress of the Communist Party of China will be held. With the regulatory uncertainties ahead, we expect Chinese outbound M&A activity to be more modest in 2017 with a potential decrease in the number and value of deals.
Chinese investors should keep a close eye on regulatory developments and review and adjust their outbound investment plans accordingly. Caution should be taken when investing in non-core sectors or speculative, over-valued projects. Deals should be carefully structured to avoid the structures targeted by the regulators (such as the use of limited partnerships and newly established shelf companies as investment vehicles). It is important that Chinese investors communicate with the regulators and banks as early as possible to anticipate and address any regulatory issues.
For foreign counterparties involved in China outbound transactions, it is crucial to keep track of regulatory developments in this area. Parties should anticipate and plan ahead for possible Chinese regulatory hurdles. Risk allocation mechanisms, such as breakup fees, should be carefully designed in transaction documents.