A one-time investment opportunity in China
By Hong Li, May Sun and Edwin Lee
Foreign investors have a rare opportunity during 2006 to profit by buying “non-tradable shares” in Chinese companies that are partly owned by the government while such shares remain undervalued and then benefit from securities market reforms that will lead to conversion of the shares into tradable securities.
The Chinese securities market is expected to grow in the next decade with continual improvements in the trading platforms of Shanghai and Shenzhen Stock Exchanges. Since the securities market reforms in the early 1990s, the total market capitalization has grown from RMB 104.8 billion in 1992 to RMB 3,364.5 billion by the end of 2005. Currently, there are 1,381 companies listed on the Shanghai and Shenzhen stock exchanges.
Market analysts point to recent consolidation of the Chinese securities market as an indication that listed companies in China are becoming safer investments. The annual trading volume on the Shanghai and Shenzhen stock exchanges increased from 3.8 billion shares to 301.6 billion shares in just 10 years from 1992 to 2002. The 2002 figure represents RMB 2,799 billion in total stock turnover.
The Chinese securities market distinguishes between A-class shares and B-class shares. The distinction is that A-class shares are subscribed and traded in domestic currency and are predominately reserved for Chinese citizens, while B-class shares are traded in foreign currencies and are open to both foreign and domestic investors. Historically, the A-class share market was seen as more exclusive. It was launched in 1990, two years before the B-class share market, and it covers all common stock issued in mainland listed companies. The A and B markets differentiate investors according to the underlying currency of their capital contributions rather than whether they are domestic or foreign investors.
The A-class share market is expected to grow more rapidly in the next decade than the B-class share market due to recent reforms in the trading of A-class shares.
The A-class share market is segmented into tradable and non-tradable shares.
Tradable shares are shares with legitimate exit rights and are reserved to domestic investors and qualified foreign institutional investors.
Non-tradable shares prevent holders from exiting through a public offering. There are three kinds of non-tradable shares: state-owned-enterprise shares, legal person shares and natural person shares.
State-owned-enterprise shares are shares in companies with assets partly or wholly funded by the state; the government owns an equity interest in the companies. For instance, if 5% of a listed company’s total equity is funded by the state, then this 5% can be defined as SOE shares while the remaining 95% non-SOEs can be issued as legal or natural person shares.
Legal person shares are shares held by a legal entity. Natural person shares are shares held by individuals and usually refer to shares issued to employees under an employee stock option plan.
Foreign investors are allowed by law to acquire both A- and B-class shares, but entrance into the A-class share market has, until recently, been limited to the purchase of non-tradable shares. Non-tradable shares represent more than two thirds of the A-class share market.
Recent Market Reforms
The original reason for segmenting the A-class share market was to protect state-owned enterprises from hostile takeovers by private investors. The State Council is gradually relaxing the restrictions as the Chinese securities markets mature.
The Chinese government first lifted the ban on foreign takeovers of Chinese companies in November 2001 in a joint release by the Ministry of Commerce and the China Securities Regulatory Commission called “Several Opinions on Relevant Issues of Listed Companies Concerning Foreign Investment.” This was the first step toward moving from a fully state-controlled market to a more western market-based system.
On September 4, 2005, the government introduced further reforms in a bulletin called “Administrative Measures on the Share Separation Reform of Listed Companies.” These latest reforms free up the A- class share market by removing the distinction between tradable and non-tradable shares.
Structure of Chinese Securities Market
Various laws, rules and industry codes have been adopted by Chinese policymakers in recent years to improve the transparency of the securities market. These rules are now continuously monitored by state agencies. There has also been greater cooperation between US and Chinese regulators to harmonize the securities practices of the two countries.
Chinese law recognizes the legal sanctity of transfers of listed shares. Shares purchasers have access to the Chinese courts to enforce their rights.
Foreign investors thinking about buying shares in state-owned-enterprises — or companies that are owned partly by the government — should find the specific industry code for the company and comply with the relevant procedures for that category of company.
For example, all share purchases in SOEs are governed by the “Regulations on the Acquisition of Listed Companies,” while specific share purchases may also be covered by the “Provisional Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors.” Each province also has its own codes that deal with specific cases of foreign investment.
In cases where there is a time lag between signing a purchase agreement and closing on the share purchase, the “Interim Measures for the Administration of State-Owned Assets” will apply. In cases where the legality of the share transfer is in doubt and there are guiding policies from government agencies, additional steps will have to be taken.
Five government agencies regulate securities transactions. The Ministry of Commerce controls foreign investment and must approve share purchases by foreign investors. The China Securities Regulatory Commission controls mergers and acquisitions of listed companies and approves foreign takeovers. The Ministry of Finance and the State-Owned Assets Supervision and Administration Commission jointly administer assignment of shares and must approve the transaction price. The State Administration of Foreign Exchange monitors foreign exchange risks.
Once a foreign investor has the necessary government approvals, the closing on the share purchase is straight forward. Settlement of the actual transfer and delivery of shares is done through the Depository Clearing Corporation system at the relevant stock exchange. Article 9 of the “Clearing Corporation Rule” stipulates that a settlement confirmation must be issued by the Depositary Clearing Corporation “within three working days after the receipt of the application.” Share purchases paid in foreign currency must be registered with the State Administration of Foreign Exchange prior to the actual transfer.
It is in the interest of every foreign investor to register transactions so that he or she will have all available legal protections later.
Alternatively, a foreign investor may obtain protection by registering the change in shareholding with the State Administration for Industry and Commerce and then applying for a renewed business license for the target company to reflect the change. This has been a popular protective strategy for foreign investors.
Continuous disclosure requirements and corporate governance monitored by the various government regulatory agencies protect shareholders from corporate fraud, misleading information, abuse of minority rights and antitrust and monopoly issues. The new disclosure rules are aimed at protecting foreign shareholders. For example, article 6 of the “Clearing Corporation Rule 2005” facilitates e-disclosure, or public disclosure via the designated website of the stock exchange, and this gives foreign shareholders faster and cheaper access to public disclosures. This is expected to improve the speed and safety of international transactions in the Chinese securities market.
Investing in SOEs
The Chinese government announced plans on August 23, 2005 to transform all tradable and non-tradable shares in the A-class share market. The reforms are expected to be completed by the end of 2006. The central government is actively encouraging provincial governments to cooperate with the reforms.
Non-tradable shares represent a significant percentage of the market capitalization of the A-class share market. The latest data suggests that only 30% of A-class market is tradable shares and remaining 70% is non-tradable shares. Since late August 2005, 26.55% of non-tradable shares have either been converted or are in the process of being converted into tradable shares. Chart 2 shows the relative percentages of tradable shares, non-tradable shares that have been or are in the process of being converted, and shares that remain non-tradable as of November 29, 2005.
Foreign Investment Opportunities
Market analysts suggest that the remaining non-tradable shares may present a highly profitable strategy for foreign investors to penetrate the A-class share market at a fair market value.
There are various strategies.
An investor might acquire non-tradable shares to increase control over the existing share capital in a partly state-owned company. Greater control lets the investor improve the management structure and add value to the shares. Non-tradable shares can then be converted to tradable to increase the market capitalization of the underlying company. The conversion will also provide greater flexibility in hedging against currency risk through the B-class share market. Further, it gives the holder of the converted shares additional exit and entry rights in the A-class share market, thereby adding further to value.
Given the potential profitability of acquiring non-tradable shares before the A-class share market reform is completed, a foreign investor would need to consider how legitimately to acquire non-tradable shares. The new reforms set out the necessary procedural requirements. The transaction stages are summarized in the chart on the following page. It is important that the parties engage in a clear dialogue with the relevant authorities. Good legal advice can mitigate the risks of delay and information asymmetry at each stage in the transaction.
The successful entrance of Mittal Steel Co. in July 2005 into the Chinese steel market is an example of the advantages of acquiring non-tradable shares as a foreign investment strategy.
Mittal is a leading world steel company that is listed in The Netherlands and operates in India and the United Kingdom. Its objective was to expand its international presence and gain access to the vast Chinese market. In January 2005, Mittal engaged in negotiation with Hunan Valin Group, a leading state-owned steelmaker with an interest in expanding internationally. Mittal could offer advance technological and management expertise, while Valin offered a chance for Mittal to gain a foothold in the world’s leading steel market. Mittal acquired a 36.67% stake in non-tradable shares from the parent company of Valin Iron and Steel Co Ltd. The price for the shares was US$338 million. The acquisition was expected to increase the value of both companies.
Transaction Stages When Buying Non-Tradable Shares
The main challenge for foreign investors buying non-tradable shares is information asymmetry, which may lead to delays and deadlocks in the transaction. This information risk may be mitigated, where the parties have substantial market knowledge of the industry, by being careful to document everything properly.
Failure to deal prudently with regulatory risk can have a number of adverse effects on a transaction. Undervaluation of an A-class share company’s assets can lead to rejection of the transaction price by the State-Owned Assets Supervision and Administration Commission as unfair. Chinese companies follow international appraisal standards. Therefore, the main difficulty foreign investors face at the valuation stage is largely informational rather than divergence in appraisal methods. This problem can be reduced through due diligence and an active dialogue.
Submissions for government approval to convert non-tradable shares to tradable shares must be accompanied by legal opinions, a feasibility study report and other materials.
Both the Ministry of Commerce and the State Administration for Industry and Commerce are actively engaged in screening out foreign investment aimed at gaining monopoly control over the Chinese market. Where a foreign acquisition represents a clear breach of antitrust and monopoly rules, it may be rejected as illegitimate after a public hearing. A foreign investor is provided with ample opportunity to challenge the basis of an administrative decision by providing additional material to rebut a claim of breach.
Anyone acquiring listed stock representing more than a 30% ownership interest must make a tender offer to all the existing shareholders. However, a foreign investor may apply to the China Securities Regulatory Commission to be exempted from this requirement. Where the share purchase can be viewed as improving the efficiency of the Chinese market or where it adds value to the internal management of a SOE, an exemption would probably be granted.