INDIAN UPDATE – Trends in Merger Control (2012 Edition)
Executive summary:
The following article Trends in Merger Control analyses the principles and trends enunciated by the Competition Commission of India (“CCI”) in the merger control orders passed to date.
Introduction: Legal Framework
The merger control regime in India is governed by the provisions of the Competition Act, 2002 (“Act”) along with the Competition Commission of India (Procedure in regard to the transaction of business relating to combinations) Regulations, 2011 (“Combination Regulations”), which came into effect on 1 June 2011. Further, the Competition Commission of India (“CCI”), on 23 February 2012, introduced the Competition Commission of India (Procedure in regard to the transaction of business relating to combinations) Amendment Regulations, 2012 (“Amendment Regulations”), bringing about significant substantive and procedural changes to the merger control regime in India.
Sections 5 and 6 of the Act are the operative provisions dealing with combinations. Section 5 prescribes asset and turnover thresholds for transactions requiring mandatory prior notification to, and approval of the CCI. Section 6 prohibits transactions which cause or are likely to cause an appreciable adverse effect on competition (“AAEC”) within the relevant market in India and treats such transactions as void. The three types of transactions that require prior approval of the CCI (“Combinations”) are:
- transactions relating to an acquisition of control, shares, voting rights or assets;
- transactions between two competitors where one is acquiring ‘control’ over another enterprise; and
- merger or amalgamation of enterprises.
Jurisdictional Thresholds
The Act mandates notification of Combinations which meet the prescribed assets and turnover thresholds, determined by reference to the audited financial statements of the enterprises immediately preceding the year in which the Combination takes place:
- Target Test – The Government of India, by way of a notification[1], introduced a de minimis target based threshold, whereby if the target enterprise (including its divisions, units and subsidiaries) has either assets of the value of not more than Rs. 250 crores (approximately USD 50 million) in India or turnover of not more than Rs. 750 crores (approximately USD 150 million) in India, it is exempt from merger notification for a period of five years (“Target Exemption”).
If the target enterprise cannot avail of the Target Exemption, then the jurisdictional thresholds based on the parties and the group test, (provided below) need to be evaluated.
A new sub-regulation has been introduced to the Combination Regulations, which provides that if, as part of a series of steps in a proposed transaction, particular assets of an enterprise (i.e. a business or a division) are moved to another enterprise (i.e. a separate legal entity), which is then acquired by a third party, the entire assets and turnover of the selling enterprise (from which these assets and turnover were hived off) will also be considered when calculating thresholds for the purposes of Section 5 of the Act. This effectively narrows the scope of the de minimis target based threshold under the Target Exemption, and is not in consonance with international best practices. The CCI adopted this view prior to introducing the Amendment Regulations in two recent merger control orders, i.e. Mitsui/Sanyo/Mahindra Ugine/Navyug (C-2011/12/14) and Saint Gobain/Shri Ram Electro Cast/Electrotherm India (C-2012/01/19), whereby the assets and turnover of the entity transferring assets to its subsidiary i.e. the target enterprise for the proposed acquisitions was aggregated with the assets and turnover of the target enterprise for the purposes of computing the jurisdictional thresholds. While the amendment ensures that transacting parties do not structure around the Target Exemption by transferring assets to a newly incorporated special purpose vehicle, an unintended consequence of the amendment is that transactions involving greenfield joint ventures (previously exempt as the prescribed turnover threshold under the Target Exemption would not be met) could require a merger control filing.
- Parties test – The thresholds prescribed under the Parties test apply to:
(a) Acquisitions – combined value of the acquirer (on a stand-alone basis) and target enterprise (including its subsidiaries, units, or divisions) in case of an acquisition;
(b) Merger – enterprise remaining after the merger; and
(c) Amalgamation – enterprise created as a result of the amalgamation.
Where the parties to the Combination derive turnover in India only – Combinations must be notified if: (1) the value of the assets of the enterprises involved in the transaction exceed Rs. 1,500 crores (approximately USD 300 million); or (2) the turnover of the enterprises involved in the transaction exceed Rs. 4,500 crores (approximately USD 900 million).
Where the parties to the Combination derive turnover in India and outside India – Combinations must be notified if: (1) the value of the assets of the enterprises involved in the transaction exceed USD 750 million, including at least Rs. 750 crores (approximately USD 150 million) in India; or (2) the turnover of the enterprises involved in the transaction exceed USD 2,250 million, including at least Rs. 2,250 crores (approximately USD 450 million) in India.
- Group Test: the Group[2] test applies to the group to which the target or the resultant entity will belong post acquisition or merger or amalgamation:
Where the group derives its turnover from India only – Combinations must be notified if: (1) the value of the assets of the “group” to which the acquired enterprise will belong post-acquisition exceed Rs. 6,000 crores (approximately USD 1,200 million); or (2) the turnover of the group to which the acquired enterprise will belong post-acquisition exceed Rs.18,000 crores (approximately USD 3,600 million).
Where the group derives its turnover from India and outside India – Combinations must be notified if: (1) the value of the assets of the “group” to which the acquired enterprise will belong post-acquisition exceed USD 3 billion, including at least Rs. 750 crores (approximately USD 150 million) in India; or (2) the turnover of the group to which the acquired enterprise will belong post-acquisition exceed USD 9 billion, including at least Rs. 2,250 crores (approximately USD 450 million) in India.
Given that India follows a threshold based regime, it is critical that the CCI issue guidance on computation of assets and turnover as there currently exist a number of grey areas.
Therefore, for a Combination to be notifiable under the provisions of the Act, it has to be unable to avail of the Target Exemption and has to fulfil either the Parties test or the Group test. The parties are required to file a notification with the CCI within 30 days of final board approval (in the case of a merger or amalgamation) or the execution of any binding document/agreement (in the case of an acquisition).[3]
The CCI has jurisdiction over Combinations outside India if they cause or are likely to cause an AAEC in India. The CCI has clarified that for Combinations occurring outside India if any of the transacting parties has a presence in India and the jurisdictional thresholds under the Act are met, a notification would be required.
Exemptions
Exemptions from the obligation to notify the CCI have been provided in Schedule I to the Combination Regulations for Combinations which are “ordinarily” not likely to cause an AAEC in India:
- 25% Threshold Acquisitions– The Combination Regulations (as amended) provide an exemption from notification where an acquirer acquires shares or voting rights that do not entitle it to more than 25% of the total shares or voting rights in a target, and the acquisition is made solely for the purpose of investment or in the ordinary course of business and does not result in acquisition of control of the target. The threshold for acquisition was increased from 15% to 25% so as to bring the merger control regime in line with the takeover regulations in India.[4] Further, the use of the word ‘entitle’ in the exemption could encompass options and convertibles within the 25% threshold, which is contrary to the position under the takeover regulations However, this could potentially affect private equity transactions if a less than 25% controlling interest were to be acquired and the transaction meets the prescribed thresholds for notification under the Act. Moreover, the CCI has failed to provide any clarity as to what constitutes “control” under the provisions of the Act. “Control” has been defined under the Act to include controlling the affairs or management of one or more enterprises or group, either jointly or singly. This definition of control is ambiguous and is an inclusive circular definition. However, very limited guidance can be obtained from CCI’s sole precedent in Alok Industries/Grabal Alok Impex (C-2011/01/28) wherein it was held that the existence of common promoters and management between two companies would indicate common control. However, the CCI in informal consultation has stated that it will determine control on a case-by-case basis. Given that the Act is largely based on the EU competition law, there may be a possibility that the CCI interprets control to include positive and negative control as EU competition law considers both positive and negative control, for the purposes of competition law analysis;Acquisitions above 50% – Where the acquirer holds more than 50% of the equity shares of a target, further acquisitions, which do not result in a change from joint to sole control are exempt. This would potentially affect impact exits in joint ventures and pre-emption rights, which meet the prescribed thresholds under the Act. Further, acquisition of shares or voting rights between 25.01% and 49.99% is not addressed by the Combination Regulations and would require notification to the CCI, even if not leading to acquisition of control. This could affect all the private equity transactions and creeping acquisitions, where thresholds are met, irrespective of whether control is being acquired or not;
- Asset Acquisitions – Acquisitions of assets which do not constitute substantial business operations: (i) in a particular location; or (ii) in relation to a particular product or service of the target, which are made solely as an investment or in the ordinary course of business, not leading to control of the target, irrespective of whether such assets are organized as a separate legal entity;
- Amended/renewed tender offers where notice has already been filed by the offeror;
- Routine business acquisitions – acquisitions of stock-in-trade, raw materials stores and spares in the ordinary course of business. This does not have any impact on the competitive landscape;
- Changes to share capital – acquisitions of shares or voting rights, not leading to control, by way of buybacks, bonus issues, stock splits, consolidation of face value of shares and rights issues even beyond the entitlement of the acquirer. However, a renunciation of rights issue which results in control would require a filing;
- Underwriting/stock broking – acquisitions of shares or voting rights in the ordinary course of business not leading to control by a securities underwriter or a stock broker;
- Intra-group acquisitions – acquisition of control, shares, voting rights or assets by a person or enterprise, of another person or enterprise within the same group;
- Intra-group mergers and amalgamations – a partial exemption for mergers or amalgamations between a holding company and a subsidiary wholly owned by enterprises within the same group and between subsidiaries wholly owned by enterprises belonging to the same group, would not require notification to the CCI. As such, there is a distinction made between acquisitions and mergers for intra-group re-organisations, given that for an intra-group exemption by way of a merger, the enterprises involved should be wholly owned within the same group, which is not case in case of intra-group acquisitions, although there is no competitive impact in either case, to raise any competition concerns.
- Acquisition of current assets in the ordinary course of business; and
- Purely offshore transactions – Combinations taking place outside India having insignificant local nexus and effect on markets in India. Thus, cross border transactions are not completely exempt from the provisions of the Act. The Act gives the CCI the jurisdiction to investigate transactions which have local nexus with India (which essentially would entail the Target Exemption) and which have an effect on the markets in India (which could necessitate an economic analysis).
Forms for Pre-Merger Notification
The Combination Regulations provide for three types of forms to be filed by the parties, depending on the nature of the Combination:
- Form I: This is the default option, requiring basic details of the Combination and transacting parties. All the Combinations thus far notified have been Form I filings. The Combination Regulations previously listed transactions for which Form I would “ordinarily” be filed, and permitted the filing of only Part I of Form I (i.e. truncated form) for certain transactions which did not have a real competition impact (for e.g., acquisitions through gifts or inheritances, acquisitions by export oriented units, etc.). However, Form I is now required to be filed in its entirety in all Combinations, with the option of filing only a part of Form I (for transactions with no real competition impact) being dispensed with by way of the Amendment Regulations. The filing fee has been significantly increased from Rs. 50,000 (USD 1,000) to Rs. 10,00,000 (USD 20,000).
- Form II: Parties may also file Form II which is fairly extensive and requires minute details regarding the proposed Combination, the parties to the Combination, their group, all products manufactured by the group, the relevant market, pricing, distribution networks, etc. The Amendment Regulations recommend that Form II should “preferably” be filed for transactions where:
(a) parties are competing enterprises and have a combined market share in the same relevant market of more than 15%; or
(b) parties are operating in vertically linked markets and the individual or combined market share in any of those relevant markets is greater than 25%.
The Form II filing fee has been substantially increased from Rs. 10,00,000 (USD 20,000) to Rs. 40,00,000 (USD 80,000).
- Form III: This post-facto intimation form is required to be filed in case of any acquisition of shares or voting rights by public financial institutions, foreign institutional investors, banks and venture capital funds, pursuant to a loan agreement or investment agreement.[5] There is no filing fee.
Even though the Amendment Regulations have provided some clarity by indicating the CCI’s “preference” as to when Form II is required to be filed, ultimately the transacting parties are required to self-assess and opt for Form I or Form II. Given that the CCI’s pre-merger consultation process is non-binding and informal and limited to procedural issues, transacting parties would have to await precedent in the form of CCI orders for greater clarity on this issue. The risk of filing the incorrect form (i.e. Form I when Form II should have been filed) is that no time credit is given for filing the incorrect Form and the clock re-starts from the date of filing Form II. This would result in an increase in transaction time and financing costs.
Timelines
The Act requires mandatory notification to the CCI providing for a 210-day suspensory regime. Notifying parties cannot complete the transaction prior to receiving approval from the CCI or until the 210 day period lapses.
However, the CCI is required to form a prima facie opinion on whether a Combination is likely to cause an AAEC within the relevant market in India, within a period of 30 days from receipt of the notification. If the CCI forms a prima facie opinion that a combination is likely to cause an AAEC, a detailed investigation will follow and the standstill obligation shall continue until a final decision is reached by the CCI or 210 days lapse from the date of filing the notification.
Further, the CCI can ‘stop the clock’ during its review period seeking additional information until such time as any information requested from the parties remain outstanding. This effectively means that the review periods provided under the Act are not absolute.
As discussed earlier, in cases where Form I is filed and the CCI requires a Form II filing, the preliminary 30-day review period would re-start from the date of filing Form II. This increased time period effectively pushes back the timelines for completion of transaction by parties in cases where incorrect notifications have been made.
Penalties
If a notifiable Combination has not been notified, the CCI can impose a penalty of up to 1% of the combined assets or turnover of the parties to the Combination, whichever is higher. Further, the Act empowers the CCI to “look back” and inquire into a Combination that has not been notified (suo motu or on the basis of information received by it) for up to one year from the date of consummation of such Combination and if the Combination causes an AAEC, it can be held to be void. A penalty of between Rs. 50,00,000 (USD 100,000) to Rs. 1,00,00,000 (USD 200,000) can also be levied for making false statements or omitting material information in the merger control filing.
The CCI may also impose penalties of up to Rs. 1,00,000 per day (USD 2,000), up to a maximum of Rs 1,00,00,000 (USD 200,000) on parties for contraventions of its orders, as well as order imprisonment for up to three years, or a fine of up to Rs. 250,00,00,000 (USD 150 million) or both. Officers in charge of a company’s business would attract liability for contraventions by companies of provisions of the Act, unless they can demonstrate lack of knowledge despite due diligence.
Even in the case of belated merger control filings (i.e. made beyond the statutory time period of 30 days after the trigger event), the CCI has initiated parallel proceedings to determine penalty, despite granting approval to the Combination. There have been five instances of belated filings, to date. However, it is notable that the CCI has chosen not to impose any penalty in its first order on penalty proceedings in the EAPL/BBTCL order (C-2012/12/16) on account of the fact that the transaction was an intra-group re-organization by way of an amalgamation, and the fact that the merger control regime is in its first year of implementation.[6] It remains to be seen as to how the CCI would treat belated filings in more complex cases with horizontal/vertical overlaps, change in control, etc.
Recent Trends in Merger Control
The CCI has reviewed 36 filings to date, and approved all the Combinations, within the initial review period of 30 days. However, in more than half of the cases, the clock has been stopped, and the total time for review has effectively exceeded the 30-day statutory period.
Given the importance of time and costs involved in concluding transactions as soon as possible, an economist’s report defining and analysing the relevant market and the impact of the proposed transaction on competition would be useful to incorporate as an additional submission along with the merger notification, even though it is not a mandatory requirement. Further, the Amendment Regulations now mandatorily require the submission of the documents that trigger a merger filing (i.e. a binding agreement or final board approval) along with the merger notification. Given that confidentiality over documents submitted to the CCI needs to be specifically claimed along with the requisite justification, parties should submit confidential and non-confidential versions of such documents, in order to protect information relating to proprietary business, trade secrets and price sensitive information.
Further, the CCI’s initial literal interpretation of the intra-group exemption (being only available to acquisitions and not to mergers or amalgamations) led to 22 notifications being filed relating to intra-group re-organizations through mergers or amalgamations. While the Combination Regulations provide for an exemption from notification of intra-group re-organizations by way of acquisitions, the CCI held in Alstom Holdings/Alstom Projects (C-2011/10/06) that intra-group re-organizations through mergers or amalgamations cannot avail of the exemption, despite the fact that intra-group re-organizations of any kind do not cause any change in control or affect the market structure and existing competition in any manner. In response to the widespread criticism of this pedantic position, the Amendment Regulations have now introduced a partial exemption to intra-group re-organizations by way of mergers or amalgamations of a parent and its subsidiary wholly-owned within the same group or subsidiaries wholly owned by enterprises within the same group. This essentially still necessitates a filing for intra-group mergers and amalgamations where entities are not wholly owned within the same group.
Nevertheless, ambiguity persists in several other areas such as the treatment of joint ventures under Section 5 (given that there is no distinction between full function joint ventures and non-full function joint ventures), the insignificant local nexus exemption and the treatment of routine asset acquisitions. In regard to acquisitions through slump sales, the CCI has taken the view, in Wockhardt/Danone (C-2011/08/03), and subsequently in Aica/BBTCL (C-2011/09/04) and NHK Automotive/BBTCL (C-2011/10/05) (all of which were advised by Amarchand Mangaldas Suresh A. Shroff&Co.) that the target for the purpose of the Target Exemption and the jurisdictional thresholds under the Act would be the vendor enterprise (in its entirety), and not merely the assets and turnover of the division/business unit being sold. As a result of this interpretation, given that the CCI is effectively taking into account the size of the parties and not the thresholds of the actual target (i.e. the business division), a merger notification would be required if a conglomerate transfers a business division or unit of insignificant value to another enterprise, as the assets and turnover of the vendor would be considered the “target enterprise” for the purpose of the Act.
An area of concern is possible jurisdictional overlaps between the CCI and other sectoral regulators. For instance, the Ministry of Corporate Affairs is currently formulating regulations for the pharmaceutical sector as it is proposed that the CCI mandatorily review all foreign direct investment into the sector even if the jurisdictional thresholds have not been crossed and operate as a check on foreign investment through brownfield joint ventures in the pharmaceutical sector in public interest. Other sectoral regulators (such as the Reserve Bank of India) are trying to exclude mergers and acquisitions in the banking sector from the purview of the CCI. Similarly, the Department of Telecommunications has reportedly sought an exemption for the telecommunications sector in India, in order to facilitate consolidation in that sector.[7] It is vital that the CCI co-ordinate with other sectoral regulators to ensure that M&A activity in India is not hampered.
Amendments to the Act have been proposed and will hopefully address some of the ambiguities to facilitate a more efficient and effective merger control regime.
Conclusion
The merger control regime in India is relatively nascent and has been in force since 1 June 2012. During this 10 month period, the CCI has been successful in sending positive signals to the business community by approving all the 36 notifications filed to date (much before the stipulated 30 day review period, if clock stops are excluded) and by introducing Amendment Regulations which clarified some of the prevailing ambiguities and inconsistencies in the merger control regime.
Whilst the CCI has addressed some of the concerns of industry, its approach towards the implementation of the provisions of the Act has been quite literal and pedantic. Nevertheless, the CCI has been receptive and has shown its willingness to be more industry friendly. It remains to be seen how the CCI develops a body of jurisprudence in line with the international best practices, addressing prevailing ambiguities and lingering interpretational issues.
[1] The Government of India through the Ministry of Corporate Affairs issued a series of notifications dated 4 March 2011 (“Notifications”). The Notifications also exempt enterprises exercising less than 50% of voting rights in another enterprise from being treated as the part of same “group” under Section 5.
[2] The Act defines “Group” to mean two or more enterprises which, directly or indirectly, are in a position to:
(i) exercise [50]% or more of the voting rights in the other enterprise (amended by the Notifications for the purposes of calculation of thresholds); or
(ii) appoint more than 50% of the members of the board of directors in the other enterprise; or
(iii) control the management or affairs of the other enterprise.
[3] The Combination Regulations clarify that “other document” refers to “any binding document, by whatever name called, conveying an agreement or decision to acquire control, shares, voting rights or assets.” Further, in the case of hostile acquisitions, any document executed by the acquiring enterprise reflecting an intention to acquire control, shares or voting rights would be considered an “other document”. Additionally, even where documents have not been executed, if the intention to acquire is communicated to a government or a statutory authority, the date of such communication would be deemed to be the date of execution of such document.
[4] The Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011.
[5] The Amendment Regulations allow the CCI to accept late Form III filings (i.e. beyond the prescribed 7 day period) and require the submission of a copy of the loan or investment agreement along with Form III.
[6] C-2012/12/16. Order of the CCI on penalty proceedings, available at http://cci.gov.in/May2011/OrderOfCommission/CombinationOrders/C-2011-12-16%2043A.pdf (last visited on 19 March 2012). Order of the CCI approving the Combination, available at http://cci.gov.in/May2011/OrderOfCommission/CombinationOrders/EAPLJan2012.pdf (last visited on 19 March 2012).
[7] “Telecom Department seeks exemption from Competition Act”, Economic Times, 19 March 2012, available at http://economictimes.indiatimes.com/news/news-by-industry/telecom/telecom-department-seeks-exemption-from-competition-act/articleshow/12323238.cms (last visited on 19 March 2012).
JAPANESE UPDATE – A Step Towards Easing Restrictions on Use of Exchange Offers by Japanese Companies Making Foreign Acquisitions
Executive Summary/Highlights:
- Japanese legal hurdles to cross-border exchange offers or triangular mergers have deterred Japanese acquirers from using their stock in cross-border acquisitions.
- A recent amendment to the Law on Special Measures for Industrial Revitalization and Innovation, which took effect on July 1, 2011, introduces a new path to facilitate exchange offers by Japanese firms by eliminating some legal hurdles.
- While the amendment is an important step forward to make exchange offers more feasible for Japanese buyers, its applicability is limited and there remain issues that must be addressed before exchange offers become a common practice inJapan.
MAIN ARTICLE
Introduction of New Rules regarding Exchange Offers by Japanese Firms
1. Exchange offers generally not feasible under existing rules
A shrinking domestic market and strong yen are driving more and more Japanese firms to seek out opportunities for overseas mergers and acquisitions. However, to date there have been only a few cases in which Japanese companies have used their stock as acquisition consideration in acquiring a foreign company. Among a variety of factors contributing to the scarcity of stock consideration in cross-border acquisitions by Japanese firms are legal hurdles in conducting cross-border exchange offers or triangular mergers under Japanese law.
In particular, exchange offers in which an acquirer’s stock is offered as consideration has not been a viable option for Japanese buyers. Because such exchange offers involve the issuance of new shares or the reissuance of treasury shares by the Japanese acquirer in exchange for contributions-in-kind of the target company’s shares tendered, the prevailing Japanese corporate law regime regarding the issuance or reissuance of shares and contribution-in-kind applies to exchange offers by Japanese firms. However, the current regime is not tailored to the unique considerations relevant to such exchange offers and as a result creates significant impediments to the use of such exchange offers. For instance:
(i) If the value of the target company’s shares significantly deteriorates following a Japanese acquirer’s decision to offer its shares in exchange for the target company’s shares tendered, the target company’s shareholders tendering their shares and certain directors of the acquirer may be personally liable for the difference between the value of the target company’s shares at the time the acquirer decides to offer its shares and the value at the time the acquirer’s shares are issued or reissued;
(ii) A review by a court-appointed inspector of the value of the target company’s shares as determined by the acquirer’s board or shareholders may be required, making it difficult to set the schedule for an exchange offer; and
(iii) If the acquirer’s stock is offered at an exchange rate that reflects a premium over the market price of the target company’s shares, a super-majority (two-thirds) approval of the acquirer’s shareholders may be required.
2. New rules under the amended Industrial Revitalization Law
An amendment to the Law on Special Measures for Industrial Revitalization and Innovation (the “Law”), which became effective as of July 1, 2011, introduces special measures that aim to eliminate several of the legal hurdles imposed by the Companies Act of Japan, subject to certain conditions. The Ministry of Economy, Trade and Industry of Japan (“METI”) promulgated this amendment in connection with its efforts to promote both domestic and cross-border mergers, acquisitions and restructuring transactions by Japanese companies as part of Japan’s growth strategy. Set forth below are some of the key points to be noted with regard to such special measures:
(1) Eligibility requirements and other noteworthy points
- First, in order to be eligible for the special measures, a Japanese acquirer must submit a plan that falls under one of the four categories of approved transactions involving exchange offers set forth in the Law, and obtain the approval of METI. The four categories are, namely, “reconstruction plan,” “plan for reuse of business resources,” “business resources integration plan, and “resource productivity innovation plan.” The plan should include the terms of a proposed transaction and elaborate the gains in productivity to be achieved by the contemplated transaction. METI publishes detailed criteria and numerical thresholds that a submitted plan must meet in order to obtain its approval.
- The availability of special measures is limited to exchange offers in which a Japanese acquirer aims to acquire “effective control” of the management of another company. In this regard, METI requires an acquirer to establish the minimum number of shares to be tendered in an exchange offer such that the acquirer will own 40% or more of the voting control of the target company following the transaction.
- The target company of an exchange offer eligible for the special measures can be either domestic or foreign.
- A Japanese acquirer can itself, or through its wholly-owned subsidiary, conduct an exchange offer. Particularly in the case of a cross-border exchange offer, a Japanese acquirer may elect to establish a wholly-owned subsidiary in the jurisdiction in which the target company is located and have it conduct an exchange offer in which the Japanese parent’s stock is offered pursuant to the tender offer regulations of the jurisdiction.
- Consideration for the exchange offer can be the acquirer’s stock or a combination of the acquirer’s stock and cash.
(2) Legal consequences of the special measures
- In the case of an exchange offer to which the special measures apply, no review by a court-appointed inspector is required (see 1(ii) above), and neither the target company’s shareholders nor the Japanese acquirer’s directors are under any obligation to compensate the Japanese acquirer for a significant decline in the value of the target company’s shares (see 1(i) above).
- Under the special measures, no approval by the acquirer’s shareholders is generally required for the issuance or reissuance of the acquirer’s shares in connection with an exchange offer (see 1(iii) above), as long as the product of the net asset amount per share multiplied by the number of shares to be delivered to the tendering shareholders of the target company does not exceed one-fifth of the net asset amount of the acquirer. Note that, in the case that a combination of stock and cash is offered as consideration, the cash portion is not counted toward the one-fifth threshold. As an exception to the foregoing, if a designated number of the acquirer’s shareholders (generally one-sixth or more of all voting shareholders) notifies the acquirer of their opposition to the proposed exchange offer within the requisite period, a super-majority (two-thirds) approval of shareholders is required to approve the issuance or reissuance of the acquirer’s shares in connection with an exchange offer.
- In addition, to afford protection to a Japanese acquirer’s shareholders opposed to a proposed exchange offer, such shareholders have the right to require the acquirer to purchase their shares at a “fair price” subject to certain conditions.
3. Issues that remain to be addressed
Although the amendment to the Law discussed above is an important step forward toward increasing the use of exchange offers by Japanese firms in which their stock is offered as consideration, there remain Japanese tax, securities law and other issues arising from such exchange offers. For example, the Japanese tax code does not allow for the deferral of capital gains tax on the part of the target company’s Japanese shareholders who tender their shares in exchange for the offered shares of the acquirer, which may act as a disincentive for the use of exchange offers. These remaining issues must be further discussed and addressed in order to provide Japanese companies with the assurances they need to make use of their stock as acquisition consideration in acquiring a domestic or foreign entity.
KOREAN UPDATE – Amendments to the Korean Commercial Code To Have Far-Reaching Implications for Korean M&A and Corporate Governance
Executive Summary/Highlights:
- The recently amended Korean Commercial Code (“KCC”), which will become effective April 15, 2012, includes an array of provisions that aim for more flexibility and transparency in corporate management, such as by introducing new forms of business entities and diverse types of stock, relaxing restrictions on dividend payments, and prohibiting the appropriation of business opportunities.
- These new concepts and regulations are expected to bring about fundamental and far-reaching changes in various aspects of business, including incorporation, corporate governance, corporate ownership and control structure, M&A, and corporate finance.
MAIN ARTICLE
On March 11, 2011, the National Assembly passed a highly anticipated bill to amend the Korean Commercial Code (the “KCC”). These amendments represent the most extensive revisions to the KCC since its inception in 1962 and are the final piece in a series of amendments attempted since 2005. They were originally prepared and proposed by the Korean government to address industrial developments and to meet changing needs. The Korean government promulgated the amendments as of April 14, 2011; the amendments will become effective one year after the promulgation date.
Set forth below are the key changes in the amended KCC that affect the practice of M&A inKorea:
1. Introduction of New Forms of Business Entities (Limited Partnerships and Limited Liability Companies)
The amendments introduce limited partnerships modeled after LPs in theU.S., which consist of general partner(s) and limited partner(s). The amendments also provide for limited liability companies modeled after LLCs in theU.S., which acknowledge the limited liability of members even while granting them autonomy to establish, manage, and structure the organization of the company.
These new forms of business entities will provide investors with access to a wide range of new investment options and are expected to facilitate investments, especially by providing alternative business structures to private equity funds and start-up companies.
2. Introduction of Squeeze Outs
The amendments also permit squeeze outs – i.e., the compulsory acquisition by a controlling shareholder (with a stake of 95% or more) of shares held by minority shareholders at fair value. In exchange, minority shareholders may require a controlling shareholder to purchase their shares at a fair price.
3. Improvements to Laws Governing Mergers – Cash-Out Mergers, Etc.
It has been unclear whether the surviving company in a merger could pay only cash as consideration for the stock of the company being merged. Under the amendments, however, the surviving company in a merger may pay the shareholders of the company being absorbed in just cash or bonds, without delivering any new shares of the surviving company to such shareholders.
Also, mergers may currently be approved by a resolution of the board of directors (in lieu of obtaining approval at a general meeting of shareholders) if the new shares issued by the surviving company represent 5% or less of the total issued shares of the surviving company. The amendments increase this small-scale merger threshold, though, from 5% to 10%.
4. Diverse Stock Types
Prior to the recent amendments, companies could issue shares with no voting rights only if such shares were classified as preferred shares. However, following the amendments, companies will be able to issue shares with no voting rights or restricted voting rights regardless of whether such shares are common shares or preferred shares (provided that the collective percentage of non-voting shares and shares with restricted voting rights shall not exceed 25% of the total issued and outstanding shares). Also, conversion rights and redemption rights, which are currently permitted for preferred shares only, will be allowed for all types of shares. Further, companies (and not just shareholders) will be permitted to exercise such conversion rights and redemption rights. The added flexibility resulting from these changes will make it easier for companies to raise capital.
In addition, the amendments will allow companies to issue no-par value stock, which is currently prohibited.
5. Relaxed Restrictions on Acquisition / Disposition of Treasury Stock
The KCC strictly limits the circumstances under which companies may acquire treasury stock, in an effort to regulate companies’ capital adequacy. However, the amendments will allow companies to acquire treasury shares in an amount up to their distributable profits. According to the amendments, companies will also be able to freely dispose of their treasury stock after approval of the board of directors, as long as such disposition is not prohibited by the articles of incorporation.
6. More Flexible Use of Legal Reserves.
The disposition of legal reserves has been strictly restricted by the KCC. Following the amendments, however, the shareholders of a company can resolve to use the legal reserves exceeding 150% of the company’s capital to pay dividends or for certain other purposes. This change will allow companies to distribute excess legal reserves to shareholders without having to transfer their reserves to capital or undergo a capital reduction.
7. More Flexible Dividend Policies
Pursuant to the amendments, dividend payments can be approved by the board of directors of a company in certain cases, instead of always having to be approved at a general meeting of shareholders, which can be an extended process. The amendments also allow the payment of non-cash dividends in addition to cash dividends.
8. Improving Regulations on Bond Issuance
Ceilings on the total permitted issuance amount of bonds will be abandoned. Further, the amended KCC will provide a legal basis for issuing a variety of bonds, including participating bonds.
9. Prohibition of the Appropriation of Business Opportunities; Expanded Restrictions on Self-Dealing Transactions
A new provision will be added to the KCC that prohibits directors of a company from causing certain of their relatives or other third parties from appropriating business opportunities that would be beneficial to the company, unless it is approved by more than two-thirds of the board members of the company.
Also, following the amendments, restrictions on self-dealing transactions (which currently apply only to directors) will apply to directors and major shareholders, certain relatives of such directors and major shareholders, as well as affiliated companies. Such self-dealing transactions will have to be approved by more than two-thirds of the board members and must be on an arm’s length basis.
10. Reduced Liability for Directors
There are currently no provisions in the KCC that provide for a reduction in director liability, except for a provision that allows shareholders to unanimously resolve to exempt a director from liability. The amendments, however, limit directors’ liability to their most recent annual salary multiplied by six (6) (in the case of outside directors, the multiple is three (3)); provided that this limit will not apply to damages resulting from a director’s willful misconduct or gross negligence.
11. Elimination of Various Restrictions on Limited Companies
The amendments will eliminate the restriction on the number of members a limited company (yuhanhoesa) may have and will allow the free transfer of membership units to third parties (provided that such transfers may be subject to restrictions set forth in the articles of incorporation). The amendments will also allow limited companies to convene general meetings of members by providing notice to members through electronic documents, subject to the members’ consent. Furthermore, limited companies will be permitted to relax the current requirement to obtain approval at a general meeting of members prior to converting the company to a joint stock company (jusikhoesa), by specifying the modified approval requirements in their articles of incorporation.
CHINESE UPDATE – The Most Recent Challenges to the VIE Structure for Foreign Investment in China
Executive Summary/Highlights:
- Reuters reported on Sept. 18, 2011 that CSRC, the Chinese securities market regulatory watchdog, submitted a report urging the State Council to “clamp down” on the VIE structures employed in thousands of investments by foreigners into domestic Chinese companies.
- The VIE structure was adopted to gain access to the sectors where China had not yet opened to foreign investors.
- If the PRC government decides to take action against the structure, it would be a huge blow to both the overseas IPOs of Chinese companies as well as private investment (both industrial and private equity) by foreign companies into Chinese companies.
- Since the story on the CSRC Report, many Chinese law firms have become very cautious or even reluctant to issue previously standard opinions on the validity of VIEs.
MAIN ARTICLE
The Challenges
Reuters reported on Sept. 18, 2011 that China Securities Regulatory Commission (“CSRC”), the Chinese securities market regulatory watchdog, submitted a report (“CSRC Report”) to the State Council (the cabinet of Chinese national government), urging the State Council, through the Ministry of Commerce of the PRC (“MofCom”), to “clamp down” on the VIE structures “used by companies such as Sina (SINA.O) and Baidu (BIDU.O) to list overseas, and employed in thousands of other investments by foreigners into domestic Chinese companies.”[1] CSRC has not confirmed this report. MofCom spokesman did report on Sept. 20, 2011 that they are in discussion with other authorities on how to regulate VIE.[2]
This was at least the third incident this year where the VIE structure was questioned. If the PRC government decides to take action against the structure, it would be a huge blow to both the overseas IPOs of Chinese companies as well as private investment (both industrial and private equity) by foreign companies into Chinese companies.
Concept
VIE, or variable interest entities, is “a term used by the United States Financial Accounting Standards Board in FIN 46 to refer to an entity (the investee) in which the investor holds a controlling interest that is not based on the majority of voting rights.”[3] It is accomplished, in the context of Chinese regulatory framework, by setting up Chinese domestic companies (“Domestic Companies”) by nominee shareholders controlled by ultimate shareholders. The nominee shareholders are usually Chinese nationals, and therefore are not subject to the market access restrictions to foreigners. The ultimate shareholders also set up one or several special purpose entities (“SPV”), often offshore, to own a wholly owned subsidiary in China (a “WFOE”). The nominee shareholders will borrow from the SPV or the WFOE, and pledge the shares of the Domestic Companies to the SPV or the WFOE. The WFOE also enters into a series agreement to get all the financial benefit from operations of the Domestic Companies. As the result, the SPV may consolidate the balance sheet of the Domestic Companies as if they were part of the SPV. Chinaaccountingblog.com has a very good article explaining how it works. [4]
The VIE structure was adopted to gain access to the sectors where China had not yet opened to foreign investors. Because the foreign investors contractually control and benefit from operation of the Chinese Domestic Companies, they effectively have bypassed the regulatory hurdles to these restricted markets. Recently, the structure has been used to bypass the regulatory requirement for foreign investors to acquire Chinese companies.
Incidents
The VIE has always been controversial. Because the effect has been for the foreign investors to penetrate the Chinese market otherwise inaccessible, the government’s effort to counter the use of VIE structure may be traced back as early as in 2006, when the Ministry of Information Industry (“MII”) requested all the telecommunication companies (the Domestic Companies) to own their own domain name, trademark, and servers etc. Nevertheless, throughout the years, the VIE structure has become more popular (while more sophisticated), and has applied in more varieties of industry from TMT to education.
The recent incident was Buddha Steel case, reported in April 2011. It was a typical VIE structure, but used for the first time in the iron and steel industry. According to the media, Hebei Province (a Northern Province of China) government advised the operating company that the VIE agreements “contravene current Chinese management policies related to foreign-invested enterprises and are against public policy.” The VIE was unwind. Buddha Steel requested that its S-1 filing with the SEC be withdrawn.[5]
In May 2011, Jack Ma, the founder of Alibaba, transferred the Alipay (the PayPal equivalent in China) from Alibaba Group, a company whose major shareholders include Yahoo!, Softbank, and Jack Ma, to Zhejiang Alibaba, a company controlled by Jack. While the details of the transfer still remain as a mystery, according to media, People’s Bank of China would refuse to grant a third party payment license, which is essential for Alipay to run payment business, to any company contractually controlled by foreigners.[6]
On August 25, MofCom issued the Rules on the Implementation of the National Security Review Mechanisms (the “New SR Implementation Rules”).[7] Under Art.9 of the New SR Implementation Rules, MofCom, for the first time in its regulatory history, highlights that it would look at the substance through forms for national security review. For that purpose, MofCom would include contractual control, i.e., VIE etc., as acquisition.
Outlook
There have been standard disclaimers in VIE opinions issued by Chinese law firms. Basically, the opinion would say that each contract (being part of the VIE structure) is legal and binding to their respective terms, but lawyers do not guarantee the government would not challenge the substance if looking at the structure as a whole. The disclaimer had been relaxed by many Chinese law firms, until recently. Since the CSRC Report, yet confirmed, many law firms have become very cautious or even reluctant to issue opinion on this issue.
There has always been risk associated with VIE structures. However, with the New SR Implementation Rules, it has become relatively clear that there is a national security checkpoint in the regulations concerning buying Chinese interests. The VIE structure is not likely to pass this checkpoint now, even if it would have in the old days. Nevertheless, it may be too early to conclude VIE would not work at all for other conventional purposes.
[1] http://www.reuters.com/article/2011/09/18/us-china-investment-idUSTRE78H0SP20110918, last visited Sept. 30, 2011
[2] http://www.cb.com.cn/1634427/20110926/278410.html, last visited Oct. 4, 2011
[3] http://en.wikipedia.org/wiki/Variable_interest_entity, , last visited Sept. 30, 2011
[4] http://www.chinaaccountingblog.com/weblog/explaining-vie-structures.html, last visited Sept. 30, 2011
[5] PRC Challenge to Variable Interest Entity Structures? , last visited Sept. 30, 2011
[6] http://www.21cbh.com/HTML/2011-6-22/4NMDAwMDI0NTk4NA.html, last visited Sept. 30, 2011
[7] http://www.mofcom.gov.cn/aarticle/b/c/201108/20110807713530.html, last visited Oct. 4, 2011
CHINESE UPDATE – Variable Interest Entity (VIE) Structure for Foreign Investment in the PRC May Face Challenge
Executive Summary/Highlights:
- The VIE structure (i.e. reliance upon contractual arrangements to control a PRC operating company) has been a popular structure in the last decade for both foreign and Chinese investors alike.
- A number of recent cases involving companies using a VIE structure have exposed the inherent defects and potential legal and regulatory risks inherent in such structure.
- The problems associated with the VIE structure as well as a concern over losing supervision powers over key companies has attracted increasing attention on the part of the Chinese regulators. Hints of a possible clampdown on the VIE structure have caused great concern to the market and investors. The number of VIE companies currently in place is likely to give the Chinese authorities pause before taking any drastic action.
- The newly introduced National Security Review System for the first time expressly clarified that foreign investors shall not evade the security review by way of contractual arrangements.
- It is likely that the VIE structure issue will be tackled by the government at some stage in the future.
MAIN ARTICLE
The variable interest entity (“VIE”) has long been a popular structure for foreign parties to invest in sectors which are restricted by China’s industrial policy to foreign investment. In addition the VIE structure has also been used as a means by which Chinese domestic entities could list offshore on international capital markets.
The first well known VIE structure was that of Sina.com in its 2000 listing on NASDAQ. Indeed the VIE structure is also commonly known as a “Sina Structure”. Sina used the VIE as a workaround structure to avoid restrictions on foreign direct investment (FDI) in the value-added telecom services sector. Since then, both foreign and Chinese investors alike have replicated the VIE structure in many other sectors of China’s economy where FDI is either restricted or prohibited to foreign investors.
In essence a VIE structure refers to a structure whereby an entity established in China which is fully or partially foreign owned (“Controlling Company”) has control over an operating company (“Operation Company”) which holds the necessary license(s) to operate in a FDI restricted/prohibited sector. As such sector is restricted/prohibited by the PRC authorities, the foreign investors are not able to directly invest in such Operation Company. Accordingly, the foreign investors adopt various contractual arrangements between the Controlling Company and the Operation Company in order to obtain de facto control over the operation and management of the Operation Company. The profits of such Operation Company would also flow back to the Controlling Company and then ultimately be consolidated by the foreign investors.
For domestic companies, especially companies in the restrictive industries without much physical assets (such as internet or telecommunication), the VIE structure was widely used to enable them to obtain financing from overseas market through overseas listings. Gradually, companies from heavy industries also started to adopt the VIE structure to list overseas and the overseas shell company started adopting such VIE structure to circumvent the approval requirement stipulated by relevant PRC M&A Rules[1].
From the government’s perspective, although there is no clear prohibition against the VIE structure in China there has also been clearly no express endorsement of the VIE structure either. Accordingly, the VIE structure has always been a grey area in the Chinese legal system. Although the VIE structure allows both the domestic and foreign investors to circumvent government reviews and regulation, this also means that the VIE structure does not have the backing of the authority and therefore the VIE structure possesses inherent defects and potential legal and regulatory risks.
Recent Alibaba case
Despite its popularity there are inherent defects and risks for the VIE structure involving: (a) the level of protection enjoyed by the beneficial owners from VIE arrangement is far lower than a direct equity holding in the Operating Company; (b) the potential conflict of interests between the legal shareholders of the Operating Company and the beneficial owners; and (c) the level of uncertainty in the enforceability of the VIE contractual arrangements between the Controlling Company and the Operating Company in the event of a dispute.
The recent case of Alibaba, a wildly popular shopping website which had a successful IPO on the Hong Kong stock exchange in 2007, is a good example illustrating the potential risks of VIE structure and that illustrates reason for possible government intervention in the future.
Alibaba’s structure is a typical VIE arrangement: Zhejiang Alibaba, a private company held by Ma Yun and acting as an operating company, was in fact controlled by Alibaba Group Holding through a VIE arrangement. No problem arose until Ma Yun decided to complete a 70% equity transfer of Alipay from Alibaba Group Holding to Zhejiang Alibaba allegedly without majority shareholders’ approval on the part of the Alibaba Group (i.e. Yahoo and Softbank). The argument from Ma Yun was that Alipay would be unable to acquire the necessary operational license from the People’ Bank of China if it was held by foreign investors.
The Alibaba matter shone a spotlight on VIE arrangements and it has been widely reported that CSRC[2], China’s securities regulator, submitted an internal report to the State Council asking the government to clamp down on this controversial yet popular corporate structure. This has resulted in even greater concerns on the part of investors and cast doubts as to the feasibility of the VIE structure going forward.
The Implication of the Report on the future of VIE structure
There have always been great controversy regarding the legality of the VIE structure, mainly because (a) it circumvents the restrictions on foreign investors making it possible for them to invest in restricted/prohibited industries in PRC; (a) it circumvents approval requirements by Ministry of Commerce (“MOFCOM”) in accordance with the M&A Rules, especially by offshore shell company making round trip investments (i.e. where PRC owned businesses and assets are owned by an offshore entity owned by the PRC owners); and (c) it may constitute price transferring and consequently result in tax evasion in some cases.
The leaked report supposedly analyses the legality of the VIE structure as well as the current status of PRC internet companies listed overseas by using VIE structure and more importantly, it recommends future overseas listings using a VIE structure should first obtain MOFCOM and CSRC approval. The leaked Report, is causing gave concerns for foreign and domestic investors alike as nothing has been officially confirmed much less what requirements will be introduced.
Notwithstanding the above, it was recently reported by the Shanghai Securities News that the Report, which was allegedly drafted by a research department of CSRC, was created solely for internal study and communication. Therefore, it is not an official report submitted to the State Council and therefore the actual implementation, if any, is unclear.
However, the investors should note that since the overseas listing of domestic companies by way of VIE structure has gradually been extended from the traditional light industries to heavy industries involving material assets (such as railways, minerals) and therefore also avoiding PRC government supervision, the motivation for the PRC government to regulate the VIE structure has become greater. Although we expect the government will not launch a severe clamp down upon the VIE structure in the short run, it is an issue very likely to be tackled by the government at some time in the future.
Potential effect from NSR system on the VIE structure
Even though currently there are no laws or regulations directly regulating the VIE structure, a newly established National Security Review (“NSR”) system by the Chinese government may prevent foreign acquisitions of domestic companies if the purpose is to evade the governmental security review. This system, similar to those in many other countries, bestows upon the government the authority to review and approve a proposed foreign M&A transaction if it involves one of several key sectors (i.e. military, key technology and agricultural products) that have a bearing on China’s national security. However, since these newly enacted security review regulations are broad and highly discretionary in practice, whether a foreign investment which uses a VIE structure in a key industry will be constituted as a M&A transaction and consequently be required to go through NSR procedure is unclear.
The NSR review may be a means by which MOFCOM may strike down transactions using the VIE structure. However, as currently no precedent case has occurred it is still uncertain whether the NSR system would be used by the government as a step to bring foreign investments using VIE structure under their supervision