United States: Inside M&A - July/August 2009

Contents

• Mergers and Acquisitions in China: Restrictions on Choice of Governing Law

• China Issues Draft Regulations on Anti-Price-Monopoly for Comments

• Chinese Government Issues Finalized Guidelines on Relevant Market Definition

Mergers and Acquisitions in China: Restrictions on Choice of Governing Law

McDermott Will & Emery has a strategic alliance with MWE China Law Offices, a separate law firm based in Shanghai. This article was authored by MWE China Law Offices lawyer David Dai.

As a country with a civil law tradition, the People's Republic of China has enacted its own written contract law that in large part adopted the UNIDROIT General Principles of International Commercial Contracts (an instrument reflecting the general principles of the international commercial contract law). However, in the area of Chinese contract law (for the purpose of this article, Chinese contract law refers to the contract law of mainland China, exclusive of Hong Kong, Macau or Taiwan), China has also kept some unique Chinese characteristics along with certain areas of uncertainty due to the limited experience of its comparatively young market economy and judicial system. Therefore, while the content of Chinese contract law is generally within the normal expectations of most non-Chinese parties, there remain certain special rules and areas of ambiguity.

As a result, foreign investors in mainland China often prefer to choose another legal system for reasons of familiarity and greater certainty. Unfortunately, their choice of governing law may be limited by their own negotiating strength in commercial transactions, as well as by various statutory restrictions under Chinese law. This article attempts to conduct a practical analysis of these statutory restrictions and their effects on the choice of law, with respect to mergers and acquisitions in China, and related implications that may arise from an uninformed choice of governing law.

General Principles on the Choice of Law Under Chinese Contract Laws

Chinese law tends to respect the will of parties to a "foreign-related" contract in choosing a non-Chinese governing law, subject to the statutory restrictions imposed by Chinese laws and regulations (Article 145 of the General Principles of the Civil Law of the People's Republic of China and Article 126 of the Chinese Contract Law).

Whether a contract is foreign-related, therefore, becomes a precondition for the parties thereof to exercise the right of choice. In other words, contracts without foreign elements are governed by Chinese law. According to the judicial interpretations of the Supreme People's Court (Article 178 of the Judicial Interpretation of the Supreme People's Court on the Application of the General Principles of Civil Laws of the People's Republic of China), to qualify as a foreign-related contract, the contract must meet one of the following conditions:

The first two of the above items (foreign parties and subject matter) are comparatively straightforward, but uncertainty still exists as to the practical meaning of the third item (contractual rights and obligations outside mainland China). In particular, the mere fact that a contract was signed outside mainland China may not, in itself, be sufficient for the contract to be deemed as foreign related by the Chinese courts.

Chinese law further imposes the following mandatory restrictions on foreign-related contracts in the choice of non-Chinese law as the governing law (Articles 6 to 8 of the Regulations Regarding the Application of Laws for Foreign-Related Civil and Commercial Disputes dated July 23, 2007, issued by the Supreme People's Court).

Contracts Governed by Chinese Law

While allowing parties to a foreign-related contract to select non-Chinese law as the applicable law for resolution of a contractual dispute, Chinese contract law also expressly provides that Chinese law must apply to Chinese-foreign equity joint venture (EJV) contracts, Chinese-foreign contractual joint venture (CJV) contracts, and contracts for Chinese-foreign joint exploration and development of natural resources that are performed in mainland China.

Moreover, according to the regulations issued by the Supreme People's Court in 2007, the performance of the following additional foreign M&A-related contracts in mainland China must be governed by Chinese laws:

The above regulations are a judicial statement issued by the Supreme People's Court with respect to judicial proceedings in mainland China. Non-judicial organizations are not necessarily bound by these regulations. Nevertheless, in practice, Chinese authorities such as the Ministry of Commerce (MOFCOM), which are charged with approving certain foreign M&A-related contracts, tend to adhere to the regulations.

General Policies on Foreign M&A in China

The Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises (the M&A Rules), enacted in 2006 by MOFCOM and five other ministerial government authorities, represented a major development in China's regulation of foreign acquisitions of China-based companies and signaled government intentions to monitor and supervise such foreign M&A activities in China to an even greater extent.

The M&A Rules set forth the general principles governing M&A activities by foreign investors in China, including the following statutory obligations of the parties to such M&A transactions:

In addition to the tightened regulation on M&A activities that may result in either a concentration of control in a given industry or control of companies in industries that are considered "key" and "sensitive" in the Chinese economy, the M&A Rules also stress the necessity of protecting national economic security in the context of foreign acquisition of domestic enterprises. Thus, the M&A Rules dictate that foreign investors must comply with MOFCOM reporting requirements in connection with acquisitions of domestic target companies engaged in key industrial sectors that affect or may affect the security of the national economy, or in connection with acquisitions of domestic target companies holding well-known trademarks or traditional brands in China (Article 12 of the M&A Rules).

To ensure compliance with the above statutory requirements by foreign investors, the M&A Rules also set forth a detailed examination and approval mechanism, including MOFCOM approval and State Administration for Industry and Commerce registration of any foreign-invested enterprises established from the acquisition by foreign investors, approval by China Securities Regulatory Commission for offshore listing of domestic equity or assets, MOFCOM approval and State Administration of Foreign Exchange registration for round-trip investments conducted by special-purpose vehicles, antitrust review by MOFCOM, national economic security reporting, etc.

Implications of Restrictions on Choosing Foreign Law as Governing Law

Given the above-noted legal restrictions on the choice of foreign laws, as well as the mandatory policies governing foreign M&A transactions in China, choosing non-Chinese law as the applicable law for M&A contracts may become very problematic.

In particular, issues may arise when approval for an M&A contract is required from Chinese governmental authorities. In practice, it is not uncommon for Chinese governmental authorities to refuse to approve certain M&A transactions until the foreign governing law in such contracts has been changed to Chinese law.

When disputes regarding such M&A contracts must be resolved in mainland China, the choice of foreign law, in contravention of the above-noted restrictions and M&A policies, will be regarded as invalid by the Chinese courts or arbitral tribunals. An invalid choice of law will thus create great uncertainty in determining the contractual rights and duties of the disputed parties under the contract.

If the M&A contract provides for arbitration in a foreign jurisdiction to resolve disputes, then a foreign tribunal may well respect the choice of law in applying conflict-of-laws principles of the foreign jurisdiction where the arbitration is conducted. However, if the counterparty is Chinese or has considerable assets located in China, there is a risk that a Chinese court could refuse to enforce any award rendered by that tribunal on grounds of violation of Chinese public policy.

Even if the choice of foreign law in the M&A contract is deemed valid, the parties must comply with mandatory policies governing M&A activities in China. Any violation of these mandatory provisions or prohibitions under Chinese laws may render the validity or performance of such M&A contracts problematic.

To avoid or mitigate potential risks in choosing foreign law as governing law for M&A contracts in China, it is usually advisable to acknowledge the above-noted legal restrictions and mandatory M&A policies by opting for Chinese governing law. In such cases, the foreign investor should have a qualified professional review the M&A contract and monitor the performance thereof to ensure that it takes into account differences between Chinese contract law and the contract law system with which the foreign investor is familiar.

China Issues Draft Regulations on Anti-Price-Monopoly for Comments

McDermott Will & Emery has a strategic alliance with MWE China Law Offices, a separate law firm based in Shanghai. This article was authored by MWE China Law Offices lawyers Henry Chen and Jacqueline Cai.

On August 12, 2009, China's National Development and Reform Commission (NDRC) published a draft version of the Regulations on Anti-Price-Monopoly to solicit opinions from the public. The draft regulations are intended to implement the Chinese Anti-Monopoly Law (AML), which took effect on August 1, 2008. The deadline for submission of comments on the draft rules is September 6, 2009.

The NDRC is one of three anti-monopoly bodies in China and is responsible for enforcement of the AML in price-related cases. The other two enforcement bodies are the State Administration for Industry and Commerce (SAIC), which has responsibility for enforcement of the AML's prohibition of monopoly agreements and abuse of dominant market positions unrelated to price, and the Ministry of Commerce (MOFCOM), which has enforcement responsibility for the AML's merger control provisions.

Enforcement Scope

The regulations are applicable to price monopolistic acts with the following characteristics:

Price monopolistic acts include price monopolistic agreements and acts that abuse dominant market position.

Price Monopolistic Agreements

A price monopolistic agreement is defined as an agreement, a decision or other concerted acts reached in oral or written form by two or more business operators to eliminate or restrict competition in relation to price. The following factors may be taken into account when defining a concerted act:

The following price monopolistic agreements among competing business operators are prohibited:

A business operator is prohibited from entering into the following price monopolistic agreements with its transaction parties:

Further, trade associations are prohibited from carrying out the following activities:

However, the above-mentioned price monopoly agreements and other prohibited activities may be exempted under Article 15 of the AML if any of the seven circumstances outlined in the article is found.

Price Monopolistic Acts That Abuse Dominant Market Position

Under the regulations, "dominant market position" means a market position held by business operators that have the ability to control the prices or quantities of commodities or other trading conditions in the relevant market, or to block or affect the entry of other business operators into the relevant market. "Other trading conditions" means factors, other than commodity price and quantity, that can substantially affect market transactions, including commodity grade, terms of payment, method of delivery, after-sale services, etc. "To block or affect the entry of other business operators into the relevant market" means excluding or delaying the entry of other business operators into the relevant market within a reasonable time period, or significantly increasing their cost of entry if they can enter the relevant market, so that they cannot effectively compete with existing enterprises, etc.

To identify whether a business operator has a dominant market position, the following factors should be taken into account:

The presumption of dominant market position of a business operator should be made based on the definition of relevant market in accordance with Article 19 of the AML. The presumption is rebuttable by any of the following evidence:

If two or more business operators are presumed to have a dominant market position, the relevant presumption can only be rebutted if the following are proved:

A business operator with a dominant market position is prohibited from engaging in the following price monopolistic acts:

Misuse of Administrative Power

Furthermore, no administrative agency or organization, as authorized by laws and regulations to perform the function of managing public affairs, may misuse its administrative power to conduct the following activities:

It is also to be noted that these regulations are applicable to any misuse by a business operator of its intellectual property rights to eliminate or restrict competition. However, they are not applicable to any joint or concerted acts conducted by agricultural producers and rural economic organizations in the production, processing, sales, transportation and storage of farm products, and other business activities.

Click here for an unofficial translation of the regulations.

Chinese Government Issues Finalized Guidelines on Relevant Market Definition

McDermott Will & Emery has a strategic alliance with MWE China Law Offices, a separate law firm based in Shanghai. This article was authored by MWE China Law Offices lawyers Henry Chen and Jacqueline Cai.

On May 24, 2009, the Anti-Monopoly Committee of the State Council issued the finalized Guidelines on Relevant Market Definition (Guidelines). However, the Guidelines were not posted on the Ministry of Commerce website until July 7, 2009.

Functions of Relevant Market Definition

The Guidelines emphasize the importance of defining the relevant market. In the works of anti-monopoly law enforcement, such as prohibiting monopoly agreements among business operators, prohibiting the abuse of dominant market position and controlling the concentration of business operators that has resulted or may result in eliminating and restricting competition, issues related to the relevant market definition may be involved.

Defining the relevant market in a scientific and reasonable manner plays an important role in key issues such as recognizing competitors and potential competitors, determining the market share of the business operators and the degree of market concentration, deciding the market position of the business operators, analyzing the impact of the business operators' behaviors on market competition, judging whether the business operators' behaviors are illegal or not, and assessing the legal liabilities they must bear if their behaviors are illegal. As a result, the relevant market definition is usually the starting point of conducting an analysis on competitive behavior and an important step of anti-monopoly law enforcement.

Concept of Relevant Market

"Relevant market" refers to the product scope and geographic scope within which the business operators compete with each other in a certain period regarding particular products or services (hereinafter collectively referred to as products). In the practice of anti-monopoly law enforcement, it is usually required to define the relevant product market and the relevant geographic market.

"Relevant product market" is a market composed of a group or a category of products that are considered by the consumers to have a relatively close substitution relationship based on factors such as characteristics, uses and prices of the products. These products demonstrate a relatively intense competition relationship, which may be considered as the product scope within which business operators compete with each other in anti-monopoly law enforcement.

"Relevant geographic market" is a geographic area within which consumers acquire the products that have relatively strong substitution relationships. Such a geographic area demonstrates a relatively intense competition relationship, therefore it may be considered as the geographic scope within which business operators compete with each other in anti-monopoly law enforcement.

The Guidelines emphasize that in the anti-monopoly enforcement of technology trade, license agreements or other issues involving intellectual property rights, the relevant technology market may need to be defined along with the influence of factors such as intellectual property rights and innovation, which may also be taken into account.

Basis for Relevant Market Definition

The Guidelines provide that the scope of the relevant market is mainly determined according to the substitution degree of the products or the geographic area of concern. Two kinds of substitutions should be taken into account: demand substitution or supply substitution.

Methods for Relevant Market Definition

Different methods of analysis may be used according to the specific circumstances. In relevant market definition, demand substitution analysis may be conducted based on factors such as characteristics, use and price of products, while supply substitution analysis may be conducted when necessary. However, if the market scope for competitive business operators is unclear or difficult to determine, the relevant market can be defined through analysis using the "hypothetical monopolist test".

The anti-monopoly law enforcement agency encourages business operators to define the relevant market according to specific conditions of the case by using objective and true data and through the economic analysis method.

Whichever method is taken to define the relevant market, it must take into account the products' basic attributes of meeting consumers' needs at any time, based on which rectification can be made on a significant deviation that occurred in the relevant market definition.

From the perspective of demand substitution in relevant product market definition, factors to be considered include, but are not limited to, the following aspects: evidence showing consumers shift to, or consider a shift to, purchases of other products due to a change of the products' price or changes of other competitive factors; the products' overall characteristics and uses, including exterior shapes, peculiarities, qualities, technical features, etc.; the products' price variance; and the products' distribution channel.

Other important factors include the consumers' preference for or reliance on the products; barriers, risks and costs associated with a switch to substitutes by a large number of consumers; and whether differential pricing exists.

From the perspective of supply, the following factors are commonly considered in the relevant product market definition: evidence showing other business operators' reactions over competitive factor changes such as a price change; the business operators' production process and crafts; difficulties in relation to a production switch; the time required for a production switch; extra costs and risks in relation to a production switch; the competitiveness of the products supplied after switch; and the marketing channels.

Main Factors to be Considered in the Definition of Relevant Geographic Market

From the perspective of demand substitution, factors to be considered include, but are not limited to, the following aspects: evidence showing consumers shift to, or consider a shift to, other geographic areas to purchase products due to a change of the products' price or changes of other competitive factors; the products' transportation cost and transportation characteristics; the actual regions in which the majority of consumers choose their products and the product-distribution locations of the main business operators; and trade barriers among geographic areas, such as tariffs, local regulations, environmental factor, technological factor, etc.

Other important factors include the consumers' preferences in a particular area and the amount of products transported into or out of this geographic area.

From the perspective of supply, the following factors are commonly considered in the relevant geographic market definition: evidence showing other business operators' reactions over competitive factor changes such as a price change, and the instantaneity and feasibility of supply or distribution of the relevant product by the business operators in other geographic areas (for example, the costs associated with switching the orders to operators in other geographic areas).

Hypothetical Monopolist Test

The hypothetical monopolist test usually begins with the relevant product market definition. Starting with the product (target product) supplied by the business operator concerned in the anti-monopoly examination, it hypothesizes that the business operator is a monopolist aiming at profit maximization (hypothetical monopolist), and the issue that will be analyzed is whether the hypothetical monopolist is able to maintain price of the target product at a small-scale increase (normally 5 to 10 percent) continuously (normally one year), provided that the sales conditions of other products remain the same. The price increase of the target product will result in consumers' shifting to other closely substitutable products, which consequently leads to a sales reduction for the hypothetical monopolist. Subsequent to the increase of the target product price, if the hypothetical monopolist is still able to achieve a profit after experiencing a sales reduction, the target product constitutes the relevant product market.

If the price increase leads the consumers to shift to other products having a close substitution relationship, rendering unprofitable the price increase by the hypothetical monopolist, such close substitutes shall be added into the relevant product market, forming a product group that consists of such substitutes and the target product. Thereafter, an examination shall be conducted on whether the hypothetical monopolist would still make a profit after the price increase of the product group. If the result is affirmative, then the new product group constitutes the relevant product market; otherwise, the aforesaid analytical process shall continue.

With the expansion of the product group, the products inside and outside the group become increasingly less substitutable. Eventually, a particular product group emerges in which the hypothetical monopolist can attain profit through a price increase. Hence, the relevant product market is defined.

Methods for the definition of relevant geographic market and the definition of relevant product market are identical. It starts from the geographic area concerned in the anti-monopoly examination (target geographic area), within which business operators carry out operational activities; the issue to be analyzed is whether it is profitable for the hypothetical monopolist to maintain the price of relevant product in the target geographic area at a small-scale increase (normally 5 to 10 percent) continuously (normally one year), provided that the sales conditions of other geographic areas remain the same. If the result is affirmative, then the target geographic area constitutes the relevant geographic market. If the massive substitution in other geographic areas makes the price increase an unprofitable act, the geographic area must be expanded until the price increase finally becomes profitable, which is then defined as the relevant geographic market.

Click here for an unofficial translation of the Guidelines by MWE China Law Offices.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.