Precautions against loss of state-owned assets

Mixed ownership reform (MOR) of state-owned enterprises (SOEs) has been a key concern among the political and business communities. This article looks at prevention of loss of state-owned assets in the process of MOR.

For a prolonged period of time, a single ownership structure and a blurred line between functions of government and enterprises have hindered SOEs from establishing a modern corporate system. In recent years, when the Chinese economy saw “L-shaped” growth amid sluggish economic growth across the world and declining demographic dividend, investment and export at home, various obstinate weaknesses of SOEs came to the surface.

The MOR of SOEs is supposed to lead to a meaningful breakthrough in the general reform of SOEs. At macro level, MOR of SOEs is conducive to organic integration between the state-owned sector and the market-oriented economy, driving ongoing development and improvement of micro market players. At micro level, it is expected to work in two ways. First, it will help state-owned capital play a bigger role in achieving value preservation and appreciation, and improve competitiveness. Second, it will drive SOEs to improve their corporate systems.

Legal risks faced by non-public sector players taking part in the MOR of SOEs

SOEs undergoing MOR by introducing domestic private capital will be the preferred receivers of support from the government, which will be provided in forms that include investment subsidies, fund injections, guarantee subsidies and discount loans. Foreign investors are permitted to take part in the restructuring and reorganization of SOEs, and to enter into joint venture with them. They are also encouraged to participate in the MOR of SOEs through overseas M&A, joint investment and financing, or offshore financial activities. Employees are permitted to participate in the MOR of SOEs under employee equity plans.

In view of this, the MOR of SOEs needs to be implemented taking into account the interests of, or representing, state-owned assets, investors, creditors, enterprises, employees and any other parties concerned. Many potential legal risks exist in the process of the MOR of SOEs. Examples include the risk of loss of state-owned assets, risks related to debt disposal and staff resettlement, the risk of non-reciprocal transactions due to the introduction of strategic investors, and the risk of change of laws or government credit risk under the public-private partnership (PPP) model. The following sections will focus on how to prevent risk of loss of state-owned assets.

Inadequate asset checking

A possible scenario could be where state-owned assets are exposed to risk of loss because an officer of the existing SOE, for the purpose of entering into any illicit transaction with any new shareholder or strategic investor and taking advantage of his or her position, hides certain state-owned assets that should have been included in the valuation. Therefore, to prevent loss of state-owned assets due to unknown reasons, the existing SOE that undergoes MOR may form a dedicated asset verification team to: (1) implement proper management of state-owned assets independently; (2) verify the assets in accordance with statutorily prescribed procedures; and (3) evaluate any capital contribution to be made in the form of asset or any other non-monetary interest from any new shareholder or strategic investor.

Improper asset valuation

A possible scenario could be where state-owned assets are lost due to false accounting data provided by the existing SOE to intermediaries, which leads to an untrue valuation or failure to evaluate assets, which ultimately exposes the MOR of the SOE to legal risks under the Company Law, Accounting Law and even the Criminal Law. As a countermeasure, we suggest that in the course of asset evaluation, both the client and valuer should comply with applicable laws and regulations and ensure that approval and/or filing procedures necessary for the evaluation are duly completed.

Related-party transactions

If the MOR of an SOE involves any related-party transactions, contracts of the transactions – particularly subject matter, quantity and amount – should be reviewed to ensure that they were executed at arm’s length. In order to prevent any related-party transaction from causing loss of state-owned assets, in addition to actual performance of the transaction, the review should focus on finding out whether: (1) the transaction is legal and compliant; (2) the transaction is detrimental to the interests of the existing SOE or any other shareholders; (3) the director in connection with the transaction has exercised (whether or not on behalf of others) the right to vote the relevant resolution; and (4) necessary approval procedures have been completed for the related-party transaction in accordance with the articles of association and relevant internal policies of the existing SOE.

Non-transparent transactions

In the process of MOR of an SOE, special attention should be paid to prevent any insider of the existing SOE from manipulating the process or colluding with any new shareholder, or strategic investor, to transfer state-owned assets at low prices.

Both parties involved in the MOR, i.e. the existing SOE and new shareholder (or strategic investor, as the case may be) should use a legal counsel to conduct due diligence on the other party so as to be informed about the intention and relevant facts of the other party. They should also accept internal oversight from management of the existing SOE, as well as external oversight from the public. The illicit transfer of state-owned assets can be prevented effectively only if all steps of the MOR are conducted properly on the basis of openness, fairness and impartiality.

Improper spin-off of assets

Before formal initiation of the MOR, relevant assets (e.g., fixed assets and intangible assets) of the existing SOE should be verified in order to identify their ownership. Any assets that are not eligible, or not necessary to be included in the MOR of the SOE, should be spun off in accordance with statutorily prescribed procedures. The MOR process should not be started formally unless the spin-off is completed, in case of any obstacles to asset checking in the process.

Breach of contract by the transferee of property ownership

If the title to any property is transferred in the course of MOR of an SOE, before the transfer legal due diligence should be conducted on the goodwill, solvency and other relevant matters of the transferee. In connection with the transfer, the conditions, period and method of price payment by the transferee should be subject to appropriate restrictions. No discount of transfer price conditional upon any payment method must be allowed, in case of actual loss of state-owned assets due to default payment by the transferee.

Author: Yu Juanjuan is a senior partner at AllBright Law Offices