From the day Deng Xiaoping opened China’s doors to the international market it has, and continues to be, one of the countries that holds great appeal to foreign investors. This interest has given rise to an exponential increase in the volume of M&A transactions involving Chinese companies, some of which have been great success stories while others have been never-ending challenges for the investors. There are good reasons why foreign investors are not put off by those challenges, and continue to strengthen their presence in China – access to a massive market, lower cost of labour, and rapid technological advances, to name a few.
China has long been associated with high levels of corruption and is one of the BRIC (Brazil, Russia, India and China) countries often cited as having higher risk. Frequently, at least in the compliance context, the term 'BRIC countries' carries the negative connotation of being high risk. However, the BRIC countries are, as we all appreciate, the economies that are anticipated to represent nearly half of global GDP by 2050. So, there are clearly good reasons to seek to invest in these countries, even with the risks and challenges associated with such investments.
In general, the most common risks are those related to the political or regulatory climate in China; the documented historical bribery and corruption risks; financial risks related to the ability to move monies in and out of China; among other operational risks. This chapter takes a closer look at several specific risks within these general categories of doing M&A deals in China. Notwithstanding these risks, with awareness of the challenges and proper planning to address those challenges, investing in China can be a viable and rewarding option for companies and investors seeking to expand into Asia.
Key considerations and risks of doing deals and investing in China
Bribery and corruption risks
The 2018 Transparency International Corruption Perceptions Index gave China a score of 39 out of 100,2 the same as Serbia and just above Bosnia and Herzegovina, Indonesia, Sri Lanka and Swaziland. Despite the crackdown on ‘tigers and flies’, an anti-corruption campaign initiated by President Xi in 2012, it appears that corruption continues to be endemic within the country and remains a key concern.
Reasons cited for bribery and corruption risks in China include a restricted press or media, ambiguous interpretation of the law, importance of the state and burdensome bureaucracy. Another reason for high levels of bribery and corruption risks in China that has been mentioned in many academic papers and media is guanxi (loosely translated as relationships). This practice of giving and receiving gifts and favours could very easily slide towards more nefarious facilitation payments or bribes.
For Chinese companies operating under enforced exterritorial laws, such as the Foreign Corrupt Practices Act (FCPA) or the UK Bribery Act, this is especially problematic. Many FCPA settlements involve an allegation of bribery and corruption occurring in China. Recent examples include the following:
- In March 2019, Fresenius Medical Care AG & Co KGaA, a German medical device company, agreed to pay US$231 million following the US Securities Exchange Commission (SEC) and Department of Justice (DOJ) investigations into the company's breaches of the FCPA in China and other countries, including bribing government officials and others through sham consulting contracts and third party intermediaries.3
- In August 2019, Deutsche Bank paid US$16 million to the SEC for the hiring of relatives of public officials in China and Russia in order to win or retain business between 2006 and 2014.4
Prior to 2018, there were concerns related to the fact that Chinese multinational companies may have had the advantage over foreign investors who were subject to stricter and wider ranging anti-bribery and corruption laws. In early 2018, China passed an amendment to the Anti-Unfair Competition Law explicitly prohibiting indirect bribery through third parties.5 This has levelled the playing field somewhat for foreign investors.
Another new development is the implementation of China’s social credit system (SCS), which is due to be substantially complete by 2020.6 The SCS has been the subject of many international news articles because of its controversial features. The system aims to give individuals a score as a judgement of their behaviour and trustworthiness (for example, traffic violations would result in a deduction in points and donating to charity would result in an increase).7 This system applies to companies as well as individuals, and is expected to have a significant impact on compliance matters.
Recent regulatory changes and a focus by the government on anti-corruption are signals that things are changing. Notwithstanding such changes, investors need to remain keenly aware of corruption risks when investing in China, both before and after any merger or acquisition.
Successor liability risk
The overarching corruption risk in the M&A context is successor liability. Successor liability is the risk of acquiring a company that is covered by the FCPA and has already violated those laws, which exposes the acquirer to potential liability based on pre-acquisition acts over which it had no control.
A few examples of corruption risk arising from successor liability include the following:
- Pfizer’s settlement with the DOJ and the SEC in 2012 encompassed FCPA violations by its subsidiary Wyeth related to bribes paid to government doctors in China that primarily occurred prior to Pfizer’s acquisition of Wyeth in 2009.8
- US medical device company AGA Medical Corp acquired its competitor in 2015, while the target was under an existing compliance monitor imposed as part of a 2012 FCPA settlement with the DOJ and SEC for bribes in Brazil, Argentina and China. Upon acquiring the target in 2015, the medical device company assumed the target’s liability and obligations under the 2012 FCPA settlement.9
- In July 2016, Johnson Controls settled with the SEC for over US$14 million related to allegations that a wholly owned Chinese subsidiary had used ghost suppliers to make improper payments in China to employees of government-owned shipyards, shipowners and other third parties to obtain and retain business.10 That Chinese subsidiary was acquired by Johnson Controls in 2005 as part of its acquisition of York International.
Such potential risks to transaction parties deserve significant attention. The DOJ and SEC’s Resource Guide to the US FCPA (the Guide) emphasises the importance of pre-closing due diligence and post-closing integration of the target into the acquirer’s compliance and internal control programmes. The Guide advocates:11
- a risk-based analysis of the target’s customer base;
- an analysis of the target’s go-to-market strategy and approach;
- a review of the target’s legal, accounting and compliance departments;
- a review of the target’s sales and financial data, customer contracts and third-party agreements (including high-risk third parties such as distributors and agents); and
- interviews with target management, not limited to those in charge of legal, sales and audit functions.
At the same time, companies need to be aware of some of the most significant challenges encountered when performing due diligence, including:
- access to (the target’s) books and records;
- low quality of publicly available information;
- fragmented information sources;
- discrepancies between company information at state and national levels;
- disorganised, incomplete and unreliable information; and
- press restrictions.
Third-party due diligence
Third-party risks in China include all of the most common risks – bribery, corruption, fraud, money laundering and conflict of interest – all of which necessitate appropriate due diligence to safeguard transaction parties and companies.
A few examples of corruption risks arising from third parties are provided below. Based on these very few examples, it is clear that performing sufficient due diligence around third parties prior to making an acquisition or investment is worth the cost:
- In 2012, Morgan Stanley’s real estate and fund advisory practice colluded with a former chairman of a Chinese SOE, where US$1.8 million worth of finder’s fees were owed to third parties in exchange for business brought to Morgan Stanley.12
- In 2014, the UK Serious Fraud Office started a formal criminal investigation into GSK’s operations in China and several other countries where the allegations included the engagement of third-party vendors to disguise illegal payments.13
- In 2018, United Technologies Corporation agreed with the SEC to pay US$13.9 million for violations by its subsidiaries Pratt & Whitney, which paid commissions to a third-party agent via a joint venture to sell jet engines to state-owned airlines, and Otis Elevator Company, which paid a kickback to an official of a state-owned bank to win a contract to install elevators in one of the bank’s branches. There were also accusations of improperly funding leisure travel for foreign officials from China and other countries.14
- In 2018, Michigan-based medical device manufacturer Stryker agreed to pay the SEC US$7.8 million for FCPA violations, including employment of unauthorised sub-distributors.15
Considerations regarding the types of M&A transactions
The common M&A transaction structures for foreign investors keen to invest in China include majority-equity subsidiaries, joint ventures, and minority investments where the risk and the decision-making rights lie with local management. These different types of investments bring different challenges to the foreign investor in China.
One might think that having a minority stake in the company (ie, where the foreign investor does not make operational decisions) is the least risky form of investment, whereas a majority or full interest, where the investor holds a majority equity interest, might be considered the safest as the investor is able to dictate how the entity is run. The ultimate selection is up to the specific investor, but each type of investment has its own set of risks and benefits of which investors should be aware.
Below are some potential risks, grouped by type of investment.
• Inability to make operational decisions
• Inability to deploy consistent group-level policies and procedures
• No access to operational matters and financial results, for example, financial results are limited to published audited financial statements only
• No access to books and records, and no right to audit
Depending on the terms and conditions set forth within the shareholders’ agreement, there may be:
• Some restrictions on decision-making at the operational level
• Some limitation on deployment of consistent group-level policies and procedures
• Limited visibility to the operations and financial results
• No or limited access to books and records, as well as right to audit
Although the foreign holding company is able to deploy aligned policies and procedures, there may be:
• Challenges in repatriation of funds from the entity
• Entire responsibility for any violations of laws and regulations by the entity
These risks are further heightened when the majority equity owner or the joint venture partner is a state-owned enterprise (SOE), as access to books and records, financial information and operation details are more often than not significantly restricted.
Data privacy regulations
A part of any M&A deal is access to data and this necessary access continues after the investment is made. Access to data brings its own set of risks and concerns both inside and outside of China. The Personal Information Security Specification is China’s national standard on the collection and processing of personal information. The May 2018 Personal Information Security Specification states clearly that consent is the preferred basis for data collection; however, two of the most significant grounds for processing under the General Data Protection Regulation (GDPR), other than consent, are disallowed in China: (i) performance of a contract, but excluding legitimate interests; and (ii) the removal of ‘contract performance’.16 As a result, US or EU companies doing business in China will not be able to process data belonging to their Chinese employees solely on the basis that they have an employment contract with said employees.
Corruption risks could also be intertwined with GDPR issues. For example, in 2018, Dun & Bradstreet entered into a US$8.1 million FCPA settlement with the SEC based on self-disclosed violations by two of the company’s China-based subsidiaries following the SEC’s allegation that the company made illicit payments to obtain data on Chinese citizens via third-party agents.17 With multiple data privacy regulations to be considered and significant focus on enforcement of these new regulations, investors must be knowledgeable in this area to avoid unintentional violations that bring serious consequences.
Other considerations and risks of doing deals in China
When investing in a foreign country, the political climate is an important consideration because regulatory changes can potentially impact business strategy, such as operational changes and changes in laws regarding foreign ownership of businesses, among others. China is a communist country with a relatively stable political situation on the whole. The Communist Party of China (CCP) has been the sole ruling party since 1949, and there are no signs of this changing in the near future. Under President Xi Jinping’s leadership, the government has gradually moved away from collective leadership and consensus-based decision making towards a centralisation of power.
Nonetheless, there are undoubtedly signs of nervousness at the top levels of government. In January 2019, during a meeting with provincial leaders of the CCP, President Xi stressed the importance of maintaining political stability and warned that slowing economic growth could result in political vulnerability. During that meeting, President Xi also put the Minister of Public Security in charge of curbing any protests that may arise.18 However, recent protests in Hong Kong have noticeably unsettled leadership in Beijing and, at the time of writing, it is unclear whether China will deploy its military forces into Hong Kong to maintain order. Doing so may bring repercussions that impact foreign investors’ operations in China. Investors should be watching these events.
China has, over the years, become less protectionist; however, when compared to many other countries, there is a higher degree of state involvement to navigate (implicit as well as explicit). Government intervention on grounds of national interests and penalties to countries that are not in alignment with government foreign policy are but two examples of state involvement in doing business in China. However, not all involvement by the Chinese government is unfavourable to investors as is evidenced by new laws being established that should, if effective, have a positive impact on foreign investment in China.
One example is the Foreign Investment Law in China, which will be effective in January 2020, which aims to improve the foreign investment framework in China and give further protection to foreign investors. This law will replace the three primary laws regulating foreign-invested enterprises (FIEs) in China: the Law on Sino-Foreign Equity Joint Ventures, the Law on Wholly Foreign-Owned Enterprises, and the Law on Sino-Foreign Cooperative Joint Ventures.19
Once enforced, the Foreign Investment Law in China will provide FIEs with the following:
- equal application of compulsory national standards;
- requirement for testing in courts before judgment on actual force of protections can be made, for example, intellectual property (IP) protections;
- free foreign exchange settlement of capital injection, capital revenues, assets disposal incomes, profits, royalty fees, compensation, indemnity, etc; and
- no expropriation of foreign investments, except, under special circumstances, the state may expropriate or requisition the investment of foreign investors for the public interest.
As the law has yet to come into effect, implementation rules and other ancillary regulations are expected to be formulated subsequently, and it remains to be seen whether the new law will actually positively impact foreign investors in China.
Impact of trade war, sanctions and anti-competition
The US–China trade war is ongoing, and while there is still appetite for M&A deals in China, M&A activity has contracted in the first quarter of 2019, likely as a result of the trade war.20 Qualcomm, for example, waited almost two years after striking the US$44 billion deal for NXP Semiconductors, a Dutch global semiconductor manufacturer, only to have to walk away from the deal in 2018 after failing to secure Chinese regulatory approval as a result of a Sino–US trade spat.21
This type of government involvement in M&A deals is not unusual for many countries, especially in the case of antitrust concerns. However, historically there has been a higher incidence of government intervention in China of the nature seen in the Qualcomm/NPX deal. Trade war and sanctions only increase the likelihood of such involvement, although these are normally temporary interruptions to deals.
Foreign currency transactions and profit repatriation from China
Foreign currency and China’s own currency, the Chinese yuan, are regulated by China’s State Administration of Foreign Exchange (SAFE). To maintain control over the fluctuation of its own currency, SAFE imposed strict restrictions on the flow of monies both in and out of China. This tight restriction, imposed on individuals as well as companies, makes it a difficult and lengthy process for monies to be remitted from China. This should obviously be an important consideration for investors and dealmakers.
Currently, the most common methods of repatriating monies out of China include:22
- remitting profits as dividends to the holding company;
- remitting inter-company fees to the holding company and companies within the group; and
- extending inter-company loans to companies within the group.
In 2016, following the weakening of the yuan, the cap for large companies to withdraw funds out of China with minimal documentation was reduced from US$50 million to US$5 million.23 This reduction means it will become more challenging to move money out of China.
In addition, investors should be aware that the SAFE has stepped up measures to stem capital outflows more generally, especially since the yuan declined to an eight-year low against the US dollar and foreign reserves fell to around US$3 trillion in 2016. Since 2016, China’s monetary authority has been imposing a series of policies to stem capital outflows, discouraging companies from engaging in non-core outbound investments and tightening inspections on citizens exchanging foreign currency. Furthermore, to show that they mean business, SAFE named and shamed five companies in 2017, alleging contract and invoice forgery to facilitate the remittance of over US$200 million offshore from 2015 to 2017.24
National secret considerations
When dealing with SOEs or handling information that may be deemed state secrets by the authorities, there is a fuzzy line between what constitutes SOE trade secrets versus state secrets. Investments and transactions involving SOEs are therefore faced with the additional challenge of needing to seek confirmation that the information they are obtaining, and possibly removing, from China is not a state secret to avoid any violations of China’s State Secret Law. Classified information is supposed to be marked as such. If it is not marked and the person who has provided the information has failed to clarify that the information is classified, the risk remains that both the party receiving the information and the party providing it may face prosecution.25
While the Classification Provisions in 2014, derived from the US legal concepts, provided more rigorous procedures and standards for secrecy officials, they do not change the standards that courts apply when adjudicating a state secrecy claim. The bottom line is that the State Secrecy Bureau and its counterparts retain maximum flexibility in terms of the interpretation of what constitutes state secrets. Therefore, care needs to be exercised when handling data and information as a violation of the State Secrets Law could lead to imprisonment or criminal detention.
The number of companies in China accused of violating environmental regulations is on the rise. China has promised zero tolerance for firms guilty of offences such as illegal waste disposal and tampering with monitoring equipment. China’s environmental protection law, in force since 2015, allows authorities to fine individuals and companies on a daily basis until the issue is rectified and allows regulators the authority to file criminal charges.
A focus on environmental issues is not unique to China. However, it does highlight that sufficient due diligence related to potential environmental issues should be performed to mitigate possible erosion of deal value.
Money laundering risks
In April 2019, the Financial Action Task Force (FATF) published a report on China’s anti-money laundering and counter-terrorist financing system. The report states that China has a strong understanding of money laundering and terrorist financing risks but should focus more on the laundering of proceeds of crime and increase the range of sources used for its national risk assessment.26 In June 2019, China’s central bank issued a statement that it would strengthen cooperation with other countries to curb cross-border money laundering activities.27
As enforcement increases and the resulting penalties and fines for violations begin to be handed out, foreign companies operating in China need to ensure that appropriate Know-Your-Customer procedures and controls are in place, specifically around politically exposed persons (PEP), in order to mitigate money laundering risks.
Nepotism and princeling hires
As mentioned earlier, guanxi is an important element in doing business in China. It is the cultural norm to help one another as part of relationship building through gestures such as referring potential job opportunities to friends and families, even if they are not qualified for the job, as a repayment or reward for bringing in deals and business. The cases mentioned below illustrate the frequency of FCPA violations involving the hiring of 'princelings' (ie, the children of government officials and other favoured referrals who did not qualify for the position they were given), demonstrating the extent to which the culture is deeply rooted within the country.
In 2016, San Diego-based Qualcomm paid US$7.5 million to settle charges of FCPA violation through the hiring of relatives of Chinese officials who were decision-makers on the selection of the company’s products.28
Also in 2016, JPMorgan Chase paid US$264 million for engaging in a systematic bribery scheme by hiring ‘princelings’.29 Three years later, in 2019, JPMorgan’s former Asia investment banking vice chair faced charges for offering employment to the son of a customer as a reward for favouring JPMorgan Securities Asia Pacific.
In 2018, Credit Suisse paid a settlement of US$77 million related to claims that the lender’s Hong Kong unit attempted to win banking business by offering jobs to friends and family of Chinese officials.30
More recently, in 2019, Deutsche Bank agreed to pay over US$16 million over charges of FCPA violations through the hiring of underqualified relatives of Chinese and Russian government officials in return for business deals.31
To mitigate such risks, referred candidates should go through the company’s standard hiring process without any bias in the selection and evaluation, and be able to demonstrate that they have the requisite skills and experience to perform the job. Individuals who are associated with the referred candidates must be removed from the hiring process to eliminate bias and the risk of conflict of interest. These issues should be a consideration when performing due diligence both before and after a transaction.
Steps to mitigate the risk of doing business in China
Having taken a look at the various key risks of doing business in China, the following are some measures to consider to mitigate the risks associated with M&A in China.
Structure and strategy
Consider the structure of the entity that best suits the business strategy; for example, how much control over the operation the investor requires. Do not underestimate the complexity of setting up an entity and unwinding structural inaccuracies.
Have a clear understanding of the restrictions for both inflow and outflow of foreign monies.
Perform appropriate due diligence pre- and post-transaction. Where possible, perform transaction testing to assess the accuracy of the verbal representations provided by the target. Ensure a proper understanding of the target’s go-to-market strategy and any third parties engaged.
Understand applicable laws and regulations
Do the homework necessary to identify and understand the various applicable rules and regulations. In some cases, the entity in China may need to be compliant with two different sets of rules – one for China and one for the holding company’s home country.
Utilise experienced advisers
When it comes to data protection regulation and state secret information, handle data and information with utmost care. Where possible, process data and information in-country and do not remove it from China. Utilising advisers (eg, attorneys, accountants, data governance professionals) can support the appropriate handling of data and assist in avoiding violations.
As corruption is endemic in China, operations in-country should be closely monitored with regular audits to identify potential breaches of laws and regulations and to create a culture of compliance.
Opportunities in China continue to appeal to foreign investors for a variety of reasons, including advantages such as low-cost labour and materials as well as advancements in technology. With a population of approximately 1.4 billion based on United Nations data as of mid-2019, it is one of the most highly populated countries.32 Given these opportunities, the risks mentioned above are unlikely to discourage foreign investors who are keen to expand their business into Asia-Pacific. Whether it is availability of employees or resources or access to the consumer market, foreign companies stand to benefit significantly from investing in China, as long as the risk exposures are managed appropriately and mitigated where applicable and possible.