SAFE Rules Make Going Abroad Harder
South China Morning Post
2005-03-29

A More Onerous Registration Process Will Make Mainland Firms Less Attractive for Foreign Investors

New regulations issued by the mainland's State Administration of Foreign Exchange (SAFE) could limit the ability of Chinese individuals to set up offshore holding companies used to list mainland assets on overseas capital markets, according to a law firm.

O'Melveny & Myers, which specialises in such transactions, warns the new rules will undermine the attractiveness of mainland firms to foreign venture and private-capital investors.

The circular, issued in January, extends SAFE regulations guarding offshore investments by enterprises to individuals. In particular, mainland residents wishing to acquire a Chinese firm through an offshore company, the technique used by Nasdaq-listed Shanda Corp, will require approval from SAFE in Beijing both for the initial offshore transaction and the mainland firm's foreign-exchange registration.

"A SAFE approval requirement obviously means a more onerous process than usual," a report by O'Melveny & Myers said. "Foreign-exchange registration has been an administrative formality in most cases and usually has been handled by the local SAFE agency ... rather than at the central level."

The report also warned that procedures needed to gain SAFE approval were not yet in place, meaning ongoing transactions were facing "serious problems".

"This is a huge mistake for China," said Walker Wallace, a Shanghai lawyer for O'Melveny & Myers. "It is likely to put a crimp on the venture capital flowing into the young, promising technology companies in the mainland."

For venture-capital firms looking to invest in mainland companies, the offshore holding structure is typically the preferred choice because invested assets would be held offshore, while the Chinese firms' mainland founders would remain majority shareholders, but through the offshore holding.

But Mr Wallace said the new regulations would limit the ability of Chinese founders to set up the offshore company, with the result that overseas venture capitalists would need to invest in the mainland firm either through full acquisition or as majority stakeholders.

"Venture capitalists want management to remain incentivised, but this will be difficult to achieve under the new regulations because [venture capitalists] will be the majority owners," he said. "Unless all the deals become control deals, it just means deals won't get done. The new regulation ... heavily penalises local entrepreneurs, who will now find it difficult to keep control of their companies.

"Perhaps SAFE is concerned that Chinese investors will be able to convert [yuan] assets into forex assets, but they're 10 years late to be worrying about this - China is already awash with foreign exchange."

Lawrence Sussman, another lawyer with the firm, emphasised the problem was "worse than simply one of delay".

"The problem is companies coming to international capital markets without a standard financing structure ... with the founders stuck onshore," he said.

However, Ben Tai, the managing director of Hong Kong-based Latitude Capital Group, doubted the new rules would severely affect the amount of private equity flowing into the technology sector, valued at US$1.26 billion in 253 firms last year by analysts Zero2IPO.

Mr Tai argued that investors were increasingly comfortable investing directly in mainland firms, especially as many expected the yuan to revalue upwards, which had reduced past fears of holding assets in the Chinese currency.

"Given another few months, no doubt people will come up with other structures with which to do overseas listings," he said.

Cash shells are increasingly popular in the United States, where listed shells raise money to acquire businesses.

"Essentially, the new regulation is making it more difficult for mainland firms to redomicile overseas," he said. "But it has no impact on acquisitions or other transactions by overseas firms."

Mr Tai believed the new rules were aimed more at tightening tax regulations than blocking legitimate investment transactions.

"This has been a major area of leakage of assets overseas and of tax dollars," he said. "Arguably, these are some of the richest people in China, so in some ways you can't blame any country for wanting to tighten these tax loopholes."

But Mr Tai agreed a management structure that did not give management a controlling stake could be a disadvantage.

"Ideally, you want the managers who are running the business to have sufficient skin in the game, sufficient equity in the company to incentivise their management."

He pointed out that Sina Corp had listed successfully in the US without the founders holding a majority stake.

"It is a new thing. It disturbed the old way of doing things, but people are definitely more comfortable investing directly in China, so this does not spell the end of private-equity investment there," Mr Tai said.

By Stuart Biggs