Foreign investors eyeing production enterprises need to tread carefully

The establishment of greenfield production enterprises involves complicated project approval procedures, with relatively long construction periods and low economic benefits. Accordingly, foreign investors frequently make their investments by acquiring PRC domestic enterprises that already exist, or are in the course of being formed, and utilise the existing production enterprise resources to rapidly gain market share. This column will analyse the major legal issues involved in this kind of investment.

Form of transactions

Pursuant to Order No. 6 of 2009 of the Ministry of Commerce, foreign investors may acquire domestic enterprises by equity acquisition or asset acquisition. If acquisition of the target company involves the disposal of state-owned assets or equity, the Law on the State-owned Assets of Enterprises, the Provisional Measures for the Administration of the Transfer of the State-owned Property Rights of Enterprises, the Provisional Regulations for Oversight of the State-owned Assets of Enterprises, etc., need to be complied with when carrying out asset appraisal and recordal procedures, as well as effecting transfer of title to state-owned assets.

The 2007 Property Law permits an enterprise to create a floating mortgage over its existing or soon to be acquired production equipment, raw materials, etc. Should the enterprise be unable to perform a due and payable debt obligation, the creditor has the right to preferential repayment from the mortgaged movables. As the large pieces of production equipment owned by a target company account for a relatively large percentage of its assets, they will have a material impact on the enterprise’s production and operation. Accordingly, it is important to check and note the encumbrance conditions of such equipment in the due diligence.

Lawfulness of production land

When a foreign investor wishes to acquire a production enterprise, the lawfulness of the production land for the target company’s workshops, plant buildings, factory, etc., is crucial to whether the enterprise can continue to operate. However, as the regulatory requirements in respect of land administration vary from place to place in the PRC, defects in the lawfulness of production land are not unheard of, including occupation of collective agricultural land to carry out non-agricultural construction, illegal approval of the occupation of land by entities that do not have the authority to make approval, etc. Pursuant to law, it is state-owned land that is to be used for industrial construction land and the relevant procedures that need to be carried out include: requisitioning of agricultural land and its conversion into industrial construction land by the competent authority; and lawful securing of land use rights by the enterprise through participation in an invitation of bids or the listing on a land exchange for granting of state-owned land use rights. Failing to do so will interrupt the target company’s operation, e.g. the land authority may order it to return the illegally occupied land, demolish and remove the facilities constructed on the land, etc.

Anti-monopoly review

The acquisition by a foreign investor, particularly a large company that occupies a dominant position in a certain production sector, could face a PRC anti-monopoly review. The Anti-monopoly Law, the Regulations of the State Council on the Criteria for Reporting Business Operator Concentrations, the Measures for Reporting Business Operator Concentrations, etc., specify that, where a business operator concentration would arise as the result of a business operator securing control over other business operators through the acquisition of equity or assets, and such business operator concentration would reach the report-triggering level specified by the State Council (the main indicator being business turnover globally as well as within the PRC), the business operator is required to first make a filing with the Ministry of Commerce, without which it may not proceed with the concentration.

If a foreign investor fails to comply with regulations on anti-monopoly reviews, the legal risks include being ordered to suspend implementation of the concentration, dispose of the shares or assets and transfer of business within a specified period of time.

Security review

The scope of reviews defined in the Notice on the Establishment of a System for Security Reviews of Acquisitions of Domestic Enterprises by Foreign Investors (Guo Ban Fa [2011] No. 6) includes: acquisitions by foreign investors of domestic military armament enterprises and suppliers to military armament enterprises; enterprises adjacent to key and sensitive military facilities and other entities that are crucial to national defence and security; and acquisitions by foreign investors of important agricultural products, important energy and resources, important infrastructure, important transport services, key technology, major equipment manufacturing and other enterprises that are crucial to national security, and where actual control may be secured by the foreign investors.

Security reviews of acquisitions are conducted by the inter-ministerial joint conference in accordance with the procedures specified in the security review notice. If an acquisition is deemed to have had, or could have, a material impact on national security, the Ministry of Commerce and relevant authorities will terminate the transaction of the parties, or take such measures as ordering transfer of the relevant equity or assets to eliminate the effect of the acquisition.

Environmental protection

In 2009, the State Council issued the Notice of the State Council Approving and Transmitting the Several Opinions of the National Development and Reform Commission and Other Authorities on Putting a Stop to Excess Capacity and Redundant Construction in Certain Industries to Guide Healthy Industrial Development (Guo Fa [2009] No. 38). The Ministry of Environmental Protection has intensified oversight in accordance with the requirements of the notice.

With respect to production enterprises, the Ministry of Environmental Protection has required environmental protection authorities at every level: (1) to order production enterprises that fail to meet emission standards or exceed total pollutant discharge targets to remedy within a specified period of time, failing which they are to be shut down; (2) to not permit enterprises whose construction projects have not passed environmental impact assessments to commence construction; and (3) to investigate and deal with production enterprises that fail to implement the environmental protection “three simultaneities” system ­­(whereby measures for prevention and treatment of pollution in a project must be designed, constructed and brought on line simultaneously with the main works) or that start production without having undergone an environmental protection acceptance check, and order them to suspend production and carry out the environmental protection acceptance procedures within a specified period.

Dorothy Xing and Tina Tang are partners at Concord & Partners