With the robust macroeconomic development of China, Chinese enterprises have tended to make more outbound investments. After the exploration and development period from 1990’s to 2000, the government-guided overseas M&A period from 2000 to 2008, nowadays, Chinese enterprises prefer to invest overseas by way of outbound M&A’s, equity participation and overseas listing for longer-term benefits with the help of more supportive governmental policies, sufficient foreign exchange reserve, relatively stable RMB exchange rates and their increasingly competitiveness. In addition, the economic recession in the U.S. and Europe caused by the financial and governmental debt crisis in recent years, has ushered to a golden opportunity for Chinese enterprises to perform outbound investments, particularly through M&A transactions.
Reviewing the historical development of Chinese overseas M&A, the total transaction value has increased from USD$1,776 million in 2000 to USD$42.9 billion in 2011, which is incredible in terms of both the volume and value of transactions. In addition, enterprises initiated M&A transactions also experienced the transition from the period dominated by state-owned enterprises to the one characterized by the emerging of private companies. Currently, it is the best time for Chinese enterprises to perform outbound investments due to the main following reasons. Firstly, Chinese enterprises have accumulated valuable experience from past failures during the last decades of overseas investment practices. For instance, through the failure in the investment project performed by CRCC in Saudi Arabia, Chinese enterprises have learnt the importance of fully justification and execution of project agreements, the enforcement of supervision on offshore state-owned assets and related accountability system, as well as the political intervention by the host government. Secondly, with the experience gained when utilizing foreign capital, Chinese enterprises are currently more practical in terms of M&A target and sectors, and have gradually achieved the diversification of M&A, changing from the traditional practice which was focused on resources and energies to multiple acquisitions of technology, brands, marketing channels, within other assets. Thirdly, as a result of the economic weakness of Europe and other major economies, some high quality offshore assets were sold at a “discount”. Chinese enterprises may enhance their self-development by acquiring other enterprises with advanced technologies and management experience at very low costs. Therefore, Chinese overseas M&A has tended to focus on developed and mature markets.
I. Trends and Characteristics of Outbound Investment Performed by Chinese Enterprises in Recent Years
1. Although facing more complicated environments, the foreign direct investments have kept steady growth
In terms of external environment, under the influence of the international financial crisis, sovereign debt crisis of developed countries and turmoil in the Middle East and North Africa, the economic recovery is slowing around the world. In terms of internal environment, China is changing its economic development mode, striving to seek balance among consumption, investment and exports, and achieve the harmonious development of the economy, society and ecological environment, resulting also in a relatively slowdown.
According to the Report on China’s Outbound Investment for 2013’s First Quarter, released by the Institute of World Economics and Politics of the Chinese Academy of Social Sciences, both the flows and the stock of China’s foreign direct investments in 2012 have hit new records with USD$77.2 billion and USD$443.2 billion respectively.
2. Invested areas has been gradually enlarged from developing countries to developed countries
In an early stage, the outbound investment area was mostly Asia. However, in recent years the investment into Europe, North and Latin America has increased rapidly, and the investment into Africa and Oceania has also increased significantly. At present, China’s outbound investment is mainly focused on North America and Europe. In 2012, China’s foreign direct investment was mainly in North America, Europe and Oceania. Among them, the investment into North America accounted for 45% of the total investment amount and 57% of the total number of projects; while the investments into Europe accounted for 17% for both the total investment amount and projects number.
During the past decade, China’s foreign direct investments were mainly performed in developing countries. In 2009, the stock of China’s direct investment in developed countries or areas was USD$18.17 billion, accounting for 7.4% of the total amount, while the investment in developing countries was more than 90%. This has been caused by several factors. On one side, China’s current economic development is restricted by resources, so it urgently needs to seek them in international markets, while numerous developing countries with abundant resources need financial aid. Hence, nowadays China and the developing countries are in a complementary situation. On the other side, compared with developed countries, China has neither obvious advantages in technologies, services and even the manufacturing sector, nor competent strength to carry out intra-industry specialized trade with developed countries. Therefore, the proportion of investments in developed countries is very low. However, with increasing risks suffered by several investments performed in developing countries such as Africa and Latin America, Chinese enterprises has been forced to reconsider their choice of the target country. For instance, recently Chinese enterprises have suffered huge losses as a result of the unstable political situation in Libya and Sudan, which has sounded the alarm for Chinese enterprises. With China’s enhanced economic strength and its transition and upgrade of industrial structure, the outbound investments by Chinese enterprises will be then more and more transferred to developed countries, which has been showed in the statistics of recent years.
3. Cross-border M&A has gradually become a major investment mechanism
The proportion of cross-border M&A’s in China’s outbound investments have increased year on year. In addition, it has become the most important outbound investment mechanism. At a press meeting held in early 2011, Yao Jian, the spokesman of the Chinese Ministry of Commerce, said that the proportion of outbound investments by Chinese enterprises performed through overseas acquisitions have gradually increased year on year. In 2010, China’s foreign direct investment achieved by means of acquisitions was USD$23.8 billion, accounting for 40.3% of the total amount, while during 2009 was USD$19.2 billion, accounting for 34% of the total value. With the gradual deepening of China’s foreign direct investment, the proportion of cross-border M&A will keep increasing.
II. Problems and Risks of Outbound Investments Performed by Chinese Enterprises
Although China’s accumulated outbound direct investment value has reached the 13th position worldwide, it still has the following disadvantages:
Firstly, low accumulated scale of outbound investment. Although the proportion of China’s exports to the global exports has jumped to 10%, the accumulated scale of China's outbound investment accounts for only 1% of the total scale of global foreign direct investment, which is about 10% of the accumulated scale of investments entered into China by foreigners. China’s overseas M&A amount only accounts 10% of that of the U.S.
Secondly, the type of investors is single. The state-owned enterprises "going out" program is the main feature of China's overseas M&A. The "sovereign fund" is generally challenged by western countries. The challenges and reviews initiated by the target country regarding the government actions in relation to Chinese M&A transactions are an important factor for the high M&A failure rate.
Thirdly, the M&A transaction skills need to be improved. Domestic investment banks, law firms, accounting firms and other intermediary agencies are not well developed, resulting in the lack of overseas M&A skills by domestic enterprises. According to the estimate of relevant institutions, compared to Anglo-American countries, the failure rate of China's overseas M&A is 12%, much higher than the developed countries one of only 2%.
Outbound investment involves at least two countries that may differ in their political systems, commercial customs, cultural background, and legal systems within other possible dissimilarities. Therefore, the risks assumed by Chinese enterprises were changed from only the production and operation risks ones of the past to more sophisticated international competitive risks.
(1) Political Risks
Refer to all political means applicable to foreign investors that may be adopted by the target country and may change the expected investment revenues, such as political unrests, wars, civil strikes, nationalization, expropriation, political upheaval, general elections within other scenarios. The political risks may eventually affect the local legal environment, including arbitrarily modification of laws, expropriation and collection of assets, increase of taxes and duties, restrictions on outflow of profits, and restrictions on swap and foreign investment.
For instance, after the war in Libya broke out, Chinese enterprises’ projects in Libya had to be suspended. CRCC has invested three railway-engineering projects as the general contractor in Libya, with a total contract value of USD$4.237 billion, but all of them have been shut down. CSCEC has invested a total amount of approximate RMB17.6 billion in Libya. However, the projects were forced to be suspended being just partially completed. CGGC also halted its house-building project with a total scale of 7,300 sets, and a contract value of about RMB 5.54 billion.
(2) Legal Risks
The major legal risks include inadequate legislation, slack law enforcement, conflict of laws and contractual risks. In specific, the legal risks in relation to outbound investments by Chinese enterprises mainly involve the national security review by the host country, the risks relating to tax law, corporate law, labor law, foreign exchange management law, accounting rules and other legal risks in relation to the investment projects.
a. National Security Review
According to laws, the State security refers to “certain safe and stable legal effects achieved by a State to recognize and protect the national interests, and to grant the State security authorities to prevent from risks and damages through legal means, and ensure the internal operation and the international status of the country against outside interference and influence." Major types of national security review include abuse of review standard, emergency legislation and post legislation.
In 2005, CNOOC claimed to acquire Unocal Corporation, a U.S. oil gas manufacturer, at the price of USD$18.5 billion. However, prior to that, Unocal have entered into an acquisition agreement with Chevron and obtained approval from the regulatory authorities. CNOOC has aroused heated debate in the U.S. Congress. Ultimately, since the House of Representatives of U.S. overwhelmingly voted against the acquisition, CNOOC subsequently withdrew its bid for Unocal. Unocal was eventually acquired by Chevron at the price of USD$17.3 billion.
b. Foreign Exchange Management Risks
The foreign exchange risks for outbound investment mainly include two aspects: the rise or fall of assets denominated in foreign currencies due to the changes in exchange rates caused by the changes in the foreign exchange market, and the legal risks of restrictions on free foreign currency exchange. The regulations on foreign exchange control of the host country may also affect the repatriation of capital and profits, frustrating the purpose of investment return.
c. Labor law risks
Labor law risk is a typical legal issue faced by Chinese enterprises when investing abroad. Most developed countries have sound labor protection laws and powerful labor unions. The latter may have great interference during the process of investments or M&A’s, the operations after the investment, or even during the processes of redundancy and investment exits. Chinese enterprises need to fully understand the relevant labor laws, such as the requirements on working hours, labor protection, social insurance and access of foreign workers. If Chinese enterprises do not comply with local labor laws, and arbitrarily adjust or lay off the staff of target enterprises, they may lead to labor union protests, strikes and even government penalties or lawsuits. Chinese enterprises have had a painful lesson in this regard.
d. Legal risks regarding financial management
The financing aspect is another common concern when investing abroad by Chinese enterprises. The relevant laws regarding financing in the target country, such as restrictions on financing mode, capital and loan ratio, etc., may affect Chinese enterprises’ choices on financing mode and structure. In addition, investors also need to consider the possibility of inconsistency or conflict between the accounting management system and the bookkeeping base currency of the target country and the current regulations of investors’ country.
e. Multi-national declaration for antitrust review
Like all other M&A transactions, outbound M&A may be subject to the business concentration declaration stipulated in the antitrust law. Moreover, since the subjects of outbound M&A are usually large-scale enterprises involving cross-border businesses, the corresponding M&A often needs to be submitted to the business concentration declaration in multiple countries. Multi-national declarations usually involve numerous consulting entities, so the effectiveness and timeliness of cooperation and communication among each party will restraint the declaration schedule to a large extent. Therefore, enterprises need to be alerted that: a. for the multi-national joint declaration, all contents in the declaration documents submitted to the relevant authorities of each country shall be consistent, except for certain country-specific contents; b. the declaration period in different countries shall be coordinated based on the declaration procedures and period requirements, so as to satisfy the closing schedule of transactions.
In addition to the abovementioned, the legal risks in the host country also include the risk of law modification occurred during the execution of M&A agreements which are out of expectation, such as raising access requirements, increasing tax burden, and other circumstances that may affect the rights and interests of M&A parties.
III. Prevention and Control of Legal Risks in Outbound Investment by Chinese Enterprises
Chinese enterprises shall adhere to the principle of “prior prevention, process control and post relief” in the prevention of legal risks during outbound investment. Instead of the post relief practices regarding risks prevention, enterprises should recognize risks and develop preventive measures in each process, immediately take measures to deal with risks and mitigate losses, keep risks within an acceptable range, and make thorough analysis on the reasons of risks and assessment of relief effect. The following will give analysis from a legal perspective on risk prevention and control:
1. Research on the general legal system of the target country
Legal systems vary from country to country. In some of them, foreign enterprises or individuals shall not be the controlling party of domestic enterprises, and some countries provide that the operating income of foreign-funded enterprises must be mandatorily settled on the basis of the official exchange rate. These regulations may become material impediments to the target’s future operations and investment income. Therefore, making a research on the general legal system of the target country is a precondition for enterprises when deciding to go overseas. Enterprises must also engage lawyers to make detailed research and confirmation on foreign investment access system, corporate legal framework, tax system, labor law system, environmental requirements, exchange control requirements and other laws and regulations closely related to the business operations and revenues of the target country. With their professional advantages, lawyers may issue a legal research report according to the enterprises’ requirements, which will be the basis and key reference for enterprises to take decisions.
2. Due diligence investigations on the target or target assets
Before signing the formal investment documents, domestic enterprises must confirm the legal qualifications and law-compliance of the target as well as the equity or assets of the target. The transaction lawyers should be coordinated with the lawyers in the host country, complete the corresponding legal due diligence investigation, and effectively avoid potential legal risks of overseas investments. If any flaws are recognized during the due diligence investigation, it may not only be the bargaining chip for domestic enterprises, but also allow the investors to make appropriate arrangements and design the structure for future equity or asset transfer or capital operation.
3. Design the transaction structure and financing mode
Based on the different focuses of domestic enterprises as the investor, lawyers shall assist in analyzing the pros and cons of each transaction structure and design different structures and overseas equity frameworks from different perspectives including reasonable tax avoidance and exit mechanisms (listing, share or asset transfer of the target), and assist domestic enterprises in choosing the financing modes including M&A financing, shareholder loan, local financial institution loan and private placement fund investment on the basis of different regulations on registered capital and financial system in the target country. During the transaction structure design, the lawyers shall fully communicate and discuss with other professional counsels, including financial counsels, tax counsels and technical counsels, so as to make overall consideration and avoid risks caused by the design of transaction design.