China's Document 11 creates hurdle for Offshore Investment

BEIJING – A policy circular issued by China’s State Administration of Foreign Exchange (SAFE) has raised serious concerns within the China private equity investment community over the future of exits on international markets by Chinese companies.

The Circular on Certain Issues of Improving Administration of Foreign Exchange in Connection with Mergers and Acquisitions by Foreign Investors has effectively put a freeze on investments by Chinese nationals in offshore companies, including the Cayman and British Virgin Islands entities that Chinese companies have typically established in order to list on international bourses.

The potential impact of the circular, which was issued in late January and is generally known as SAFE Document 11, was one of the topics of liveliest discussion at the China Venture Capital Forum 2005, which ended Saturday in Shenzhen. The circular, which has not become law but is nonetheless already being enforced by SAFE, was intended to close a loophole in foreign exchange regulations by which billions of dollars of hard currency were leaving China annually and coming back to the mainland as FDI—a practice called “round-tripping” which allows a company to benefit from tax holidays and other preferential treatment given to foreign investment.

SAFE has been vigilant in preventing some forms of capital flight by limiting levels of repatriation of hard currency by foreign-invested enterprises in China and regulating foreign investments by securities, pension and insurance funds. Document 11 seeks to extend controls to foreign investments by private individuals.

But Document 11 may have “unintended collateral damage” on the exit market for Chinese companies, said Robert Woll, managing partner of the Hong Kong office of law firm Morrison & Foerster, which has served as legal counsel in more than a dozen acquisitions and IPOs by Chinese companies. “This could impact every single deal in the pipeline.”

Big companies

Chinese entrepreneurs pursuing eventual exits either through M&A or a public listing on an international bourse have all used an elaborate structure to circumvent existing PRC laws forbidding the direct listing of a Chinese company. The list of companies using such structures includes not only familiar Nasdaq-listed Internet and technology firms, but also large state-owned companies such as the four major telecommunications carriers, China Telecom, China Unicom, China Mobile, and China Netcom, which have listed on the New York Stock Exchange.

The structure characteristically involves the setting up of an offshore holding company, usually either a British Virgin Islands or Cayman company, in which the entrepreneurs themselves participate in both an equity and management capacity. The offshore entity then sets up a wholly foreign-owned enterprise (WFOE) in China, and in the case of “restricted industries” involving, for example, Internet content, advertising, or online gaming, then contracts with a domestic Chinese limited liability company which actually holds the pertinent licenses. In an exit event, such as an IPO, it is the offshore entity that actually lists. “This has become the main paradigm, and the SEC has grown comfortable with this structure,” said Mr. Woll.

David Wang of Chinese VC Legend Capital downplays the possibility that SAFE will attempt to enforce its policy retroactively, and said companies that have already established offshore entities and are heading for public listing, including Beijing-based handset design firm TechFaith (in which Intel is a major investor, and which filed with the SEC last week) and search engine Baidu, which plans a fall listing, will not be affected. However, new approvals for investments in offshore companies that have been submitted recently have been turned back by SAFE: “Nothing that’s gone up in the last two months has been approved,” said Mr. Wang.

Illiquidity threat
For private equity-backed firms, listing on domestic stock exchanges is not an option. In contrast to China’s robust macroeconomic growth over the last two decades, the country’s bourses have performed abysmally, reaching six-year lows last week. By Chinese law, a “legal person,” usually the CEO or chairman of a firm, is required to hold roughly one-third of shares in a company, called “legal person shares,” which cannot be traded. “Because of the liquidity factor, you must have an offshore company, or you’re stuck with illiquid shares,” said Mr. Woll. “That would be a complete catastrophe for a private equity investor.”

Document 11 has not been endorsed by the Ministry of Commerce (MOFCOM), the China Securities Regulatory Commission (CSRC), or any other relevant bodies so far, and insiders have speculated that the silence is significant. Beijing has endorsed venture capital as critical to stimulating technological innovation, and has not sought to impede the listings of VC-backed tech firms since the first few Chinese companies listed on the Nasdaq in 2000. Mr. Wang of Legend Capital believes that specific regulation will be issued in the first half of May.

Investors, entrepreneurs, and lawyers are all trying to come up with ways to legally circumvent Document 11 should it really grow teeth. But Mr. Woll doesn’t think it will come to that: “I’m confident that the regulators will pursue an enlightened path, because they are increasingly sophisticated and understand the importance of this technology ecosystem to China’s economic development,” he said.