By Daniel B. Levine
In recent years, as Chinese outbound investments have accounted for a growing share of global mergers and acquisitions transactions, Chinese investors have become increasingly experienced and sophisticated dealmakers. Chinese investors often have internal teams capable of conducting detailed due diligence and complex negotiations. They engage leading financial, legal and public relations advisors. They participate in high-profile auctions and distressed situations. And occasionally, though still infrequently, they make unsolicited bids for foreign public targets.
Chinese investors are nonetheless limited in their ability to compete with non-Chinese investors by the heightened risk profile they present to foreign targets. To compensate for such risks -- that is, to put themselves on a more-even playing field with their non-Chinese competitors -- Chinese investors frequently offer substantial premiums to bids by non-Chinese investors. Often that isn’t enough, as targets opt for cheaper but surer suitors.
There are four key risks presented by Chinese bidders for investments or acquisitions in the United States that are absent from similar transactions by U.S. bidders: the risk that Chinese authorities will not approve the export of capital required for the buyer to close the transaction; the risk that the U.S. government, through the national security review process administered by the Committee on Foreign Investment in the United States (CFIUS), will prohibit the transaction from closing, or will permit it to close only if the parties accept certain “mitigation” conditions; the risk that Chinese financing sources will fail to provide the financing required for the buyer to close the transaction; and the risk that the terms of the acquisition or investment agreement will not be enforceable against the Chinese party in China.
What is the nature of these risks and what are the most successful strategies for addressing them?
CHINESE GOVERNMENT OUTBOUND APPROVALS: NATURE OF THE RISK
Chinese outbound investments are generally subject to review by three Chinese government bodies. The National Development and Reform Commission (NDRC) requires investors to make a “record filing” and obtain a “record filing notice” or, for a narrow set of sensitive transactions, to undergo “verification and approval.” The Ministry of Commerce (MOFCOM) requires investors to obtain an “overseas investment certificate.” The State Administration of Foreign Exchange (SAFE) requires that the exchange of renminbi for foreign investment projects be registered.
The published regulations provide for an expedited and, for the most part, limited review process. As of early 2016, many Chinese investors and their counsel considered the process predictable and low-risk.
However, the reality has proven different for many transactions. Through the end of 2016 and into 2017, in response to falling foreign currency reserves, the Chinese government used the lever of the approval requirements to limit outbound investment. Market participants came to expect that NDRC’s review would take six weeks or more, notwithstanding a regulatory deadline of seven business days. SAFE refused to process registrations for many transactions. And, in December 2016, the government confirmed that it was applying heightened scrutiny to transactions in certain sectors and by certain categories of investors, and that additional procedures would be required, even in the case of signed transactions pending closing. 
In recent months, the Chinese government has signaled support for continued outbound investment. But the market’s perception of the risk in the approval process has changed. The strategy for obtaining the approvals, and the consequences for failing to obtain them, are now business-level issues for contracting parties, which are often discussed at early stages of negotiations.
Transaction agreements have developed a common approach to addressing the risks: Each party’s obligation to close will be conditioned on all PRC government approvals for the transaction having been obtained, and no law or order from any government entity being in place that prohibits the closing. The buyer will be required to pay the target a “reverse termination fee” if the transaction is terminated due to the Chinese government approvals not having been obtained (but all of buyer’s other closing conditions having been satisfied) as of a defined end date, typically six to ten months after signing, or a Chinese government entity entering an unappealable law or order that prohibits the closing.
Reverse termination fees related to Chinese government approvals vary widely, in recent public deals from as low as 2.9 per cent of the target’s equity value to 7.8 per cent of equity value. Higher fees shift more of the approval risk to the buyer, but it is difficult to assess how much has been allocated in any particular case. A buyer can try to persuade a wary target by offering either a high premium or a high reverse termination fee. And the failure of a transaction to close may result in different opportunity costs for different targets, depending on the target’s financial health and the availability of alternate suitors.
Arranging for these fees to be paid presents a unique problem, for just as the failure to obtain outbound approvals prevents the buyer from using Chinese capital to close the transaction, so too does it prevent the buyer from using Chinese capital to pay the reverse termination fee. Targets have addressed this issue in a variety of ways, including requiring the buyer to deposit the fee amount in an escrow account outside of China at the time of signing (though this requires access to offshore funds); requiring the buyer to obtain a letter of credit or guarantee from a non-Chinese guarantor to secure the buyer’s obligation to pay the fee to the target; or requiring the buyer to obtain a letter of credit or a guarantee from a Chinese guarantor to secure the buyer’s obligation to pay the fee to the target’s Chinese subsidiary.
THE ROLE OF CFIUS: NATURE OF THE RISK
CFIUS has the authority to examine any transaction that results in a foreign person controlling an existing U.S. business for its impact on U.S. national security.2 The committee proceeds via a 30-day “review” and, if it believes warranted, a 45-day “investigation.” Thereafter, and taking into account any divestitures or other post-closing commitments that the parties may negotiate with the committee to mitigate national security risks, CFIUS can either certify that the transaction presents no unresolved national security concerns, or instead report the transaction to the president. Upon receiving such report, the president can allow the transaction to proceed, block it from proceeding, or, for transactions that have already closed, take no action or require the transaction to be unwound.
Notifying CFIUS of a transaction is voluntary. However, if parties believe that CFIUS will be interested in a transaction, they typically notify the committee through a formal joint filing. By acting proactively, parties improve the negotiating dynamic and the likelihood of a favorable outcome.
Only a small fraction of transactions reviewed by CFIUS, which represent only a fraction of the foreign direct investment transactions in the United States, are forwarded to the president or are withdrawn by the parties in advance of such action.3 Yet the possibility that CFIUS will recommend presidential action, or will only not recommend presidential action only if the parties accept onerous mitigation terms, represents a material risk for many transactions involving Chinese investors. Experienced counsel can substantially help parties to anticipate CFIUS’s attitude toward potential deals and, in preparing the parties’ filings and negotiating with the committee, to reduce the risk of adverse actions.
When parties intend to file with CFIUS, they generally provide the following in their transaction agreement:
Each party’s obligation to close will be conditioned on “CFIUS approval” having been obtained, defining such term as CFIUS notifying the parties that it has determined that there are no unresolved national security concerns posed by the transaction, or the president electing to allow the transaction to proceed (where CFIUS has requested such decision). The buyer’s obligation to close will further be conditioned on CFIUS not imposing any “burdensome conditions” in providing its approval, such as any conditions having a material adverse effect on the target (or the buyer and the target) post-closing, or that would materially impair the economic benefit the buyer expected to derive from the transaction.
Each party will be obligated to use its reasonable best efforts to take all actions necessary, proper or advisable to obtain CFIUS approval. Often such actions are specified to include the buyer consenting to a range of mitigation conditions, including limitations on its freedom of action with respect to, or ability to retain, the target’s assets or businesses post-closing, or to exclude the buyer consenting to the same burdensome conditions described above.
Each party will also have a right to terminate the transaction if CFIUS approval is not obtained by a defined date or if the president issues an order under the CFIUS statute prohibiting the closing. In some cases, termination for such reasons will trigger the buyer’s obligation to pay a reverse termination fee.
As in the context of the Chinese government outbound approvals, tying reverse termination fees to CFIUS events compensates the target for possible opportunity costs and allocates risk to the buyer. Chinese investors have historically resisted agreeing to pay a fee for U.S. regulatory actions that they perceive as overly-sensitive to national security interests. However reverse termination fees can be a more efficient way for a buyer to address a target’s concerns about CFIUS risk than offering a higher deal premium. And indeed investor attitudes may be evolving in this direction. In one recent transaction, the buyer committed to paying a CFIUS-related reverse termination fee of approximately 2 percent of the target’s equity value and later raised such fee to 2.5 percent of equity value in response to a competing bid.
Another way to reallocate CFIUS risk is for the buyer to agree to close the transaction even if CFIUS demands onerous mitigation. To do so, the buyer’s reasonable best efforts obligation can be defined to exclude only a narrow category of burdensome conditions, or not to exclude burdensome conditions at all (a so-called “hell or high water clause”). Notably, this does not eliminate CFIUS risks, as nothing requires CFIUS to propose mitigation conditions before reporting a transaction to the president.
RISKS OF THIRD-PARTY FINANCING FROM CHINESE SOURCES: NATURE OF THE RISK
Like other cross-border investors, Chinese outbound investors often rely on third-party debt or equity financing to fund corporate investments. Potential targets scrutinize such funding sources for their ability to make the proposed funding and their commitment to do so, as set forth in a commitment letter delivered prior to the signing of the underlying transaction. Definitive financing documents are finalized in the pre-closing period and the funding is made at closing.
Additional issues arise when Chinese investors rely on equity co-investors or lenders from China. First, equity co-investors, if they intend to deploy capital from China, must go through the same outbound approval process as the lead investor. Yet China’s regulators may view a co-investor’s investment more critically than they view the lead investor’s -- for example, if the investment is outside of the co-investor’s core industry or if the co-investor is a newly-formed special purpose vehicle. Thus the co-investor’s participation in a transaction can raise the overall risk level of a project, even when the co-investor is willing and financially able to make the investment.
Second, Chinese lenders, when committing to provide debt financing, are generally unwilling to provide the same degree of certainty as non-Chinese lenders that they will fund their commitments. Debt commitment letters from non-Chinese lenders typically set forth the material terms of the financing and a limited set of conditions to the lender’s obligation to fund. Whether such conditions -- such as the non-occurrence of a material adverse event -- are met is out of the lender’s control. Such letters are heavily negotiated and can run 30 pages or more in length, and market participants have a high degree of confidence they will be performed according to their terms.
Commitment letters from Chinese lenders, on the other hand, generally make simple commitments to fund the proposed transaction. Such commitments may be subject to factors within the bank’s control, such as their further due diligence review or credit committee approval. The letters may be silent on the terms of the funding, other than the amount to be lent, thus raising the possibility that the funding will be offered, but on terms that render the transaction uneconomic for the borrower. And, given the limited number of potential lenders in China, lenders are unlikely to suffer significant reputational harm if they fail to fund their commitments.
Transaction agreements for Chinese outbound investment generally address the risks associated with third-party financing as follows: The buyer will represent at signing that the applicable commitment letters are in effect and that, if the financing is made, it will have sufficient funds to close the transaction. The buyer will agree to use its reasonable best efforts to obtain the financing described in the commitment letters and, if such financing is unavailable, to seek alternative financing. The buyer’s obligation to close the transaction will not be conditioned upon it having received the initial or alternative financing. The target will have a unilateral right to terminate the transaction and to require the buyer to pay a reverse termination fee if the buyer fails to close the transaction despite all of the buyer’s conditions being met and the target certifying that it is willing to close.
If the buyer fails to close a transaction because of a financing failure, many agreements make clear that the target cannot sue for specific performance to force the buyer to close. Rather, the target’s only recourse will be either to enforce the buyer’s covenant to seek alternative financing which the buyer still may not obtain or to terminate the agreement and to collect the reverse termination fee. When financing risks are heightened, such as when the financing party’s commitment is subject to a wide range of conditions, targets demand larger reverse termination fees or a greater deal premium.
When a target is particularly concerned about financing risk, Chinese investors may consider offering a larger reverse termination fee for a financing failure than for the failure to obtain Chinese government outbound approvals. Doing so makes sense if the buyer thinks that its lenders (in the case of a debt financing) are highly likely to finance a deal once it has obtained its government approvals. If the likelihood of receiving the approvals but not the financing is small, then so will be the risk of having to pay the higher fee for the financing failure.
ENFORCEMENT RISK: NATURE OF THE RISK
Buyers and targets in Chinese outbound investment transactions must navigate various impediments to making their contracts enforceable, both in theory and in practice. First, China and the United States have yet to execute a treaty providing for mutual recognition and enforcement of court judgments in commercial cases. China is, however, a signatory to the New York Arbitration Convention, which requires it to recognize foreign arbitral awards. Parties thus generally opt for dispute resolution through arbitration, even if they would otherwise prefer litigation.
Unfortunately, enforcing arbitral awards in China can be costly and time-consuming. Foreign parties fear local bias. And even if Chinese courts recognize the validity of a foreign arbitral award and China’s obligations under the New York Convention, there is no guarantee that the award will be enforced. A foreign award requiring a Chinese buyer to close a transaction, for example, may be particularly hard to enforce in practice.
A more fundamental challenge arises under Article 25 of NDRC’s outbound regulations.4 Such provision prohibits a Chinese outbound investor from entering into a “final and legally binding” transaction agreement before NDRC approves the transaction, unless the agreement provides that it will become effective only upon receipt of such approval. Although this provision seems yet to have been tested in Chinese courts, it likely poses a substantial barrier to a foreign party enforcing a foreign award based on Chinese party’s breach of a transaction agreement prior to its receipt of NDRC’s approval.
As noted above, Chinese outbound deals commonly use offshore guarantees, letters of credit, or escrow funds to support reverse termination fee obligations. If the target can draw on such instruments or accounts without seeking enforcement in China, and without the applicable adjudicating body assessing the enforceability in China of the underlying obligation, enforcement risks can be largely avoided. Unfortunately, for buyers with few assets outside of China at the time of signing, entering into an offshore guarantee or letter of credit or, as noted above, funding an offshore escrow account may be difficult. In such cases, offering a higher deal premium may be the buyer’s best approach to addressing the target’s concerns about enforceability.
To maximize the chances of successfully negotiating the foregoing risks, Chinese buyers and U.S. targets can take several general steps. Before negotiations start, seek to understand the risks in the contemplated transaction, even when it is your counterparty who will be most exposed. Develop a plan for negotiations. And address the risks as forthrightly as possible with your counterparty. Learning of risks in course of negotiations can undermine trust. Whereas working together can allow parties to identify creative solutions and to clear these and other impediments to mutually beneficial transactions.
(Editor’s Note: May vary slightly as published.)