Welcome to this new edition of China Insight. This publication aims to keep you regularly informed of the most recent and substantial regulatory changes being introduced in China.
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The foundations for LBOs in China - Acquisition finance rules
Following the lead of the Chinese State Council which recently announced a massive fiscal stimulus package, the China Banking Regulatory Commission (CBRC) has overhauled the merger and acquisition (M&A) acquisition finance regime. It has provided the framework for increased availability of leverage for foreign investors contemplating onshore acquisitions in China and has therefore expanded the business opportunities for foreign banks with subsidiaries in China.
The guidelines issued by the CBRC on ‘Risk Management of Loans Extended by Commercial Banks for Mergers and Acquisitions’ on 6 December (Guidelines) look set to provide a timely boost to domestic Chinese M&A and foreign M&A by Chinese companies. However, though the Guidelines bring a necessary deregulation to the Chinese regulatory environment by shifting the burden of responsibility for lending and risk appraisal to commercial banks in the Chinese economy, it remains to be seen how quickly or freely available M&A financing will be in practice. With poison pills inserted in the Guidelines (for example through extensive risk assessment and due diligence procedures and through the somewhat vague requirement for an ‘industrial and strategic correlation’ of the contemplated M&As with the business of the borrower), the CBRC still keeps a strong grip on the development - and success - of acquisition finance in China.
A Boost to Inbound and Outbound M&As
At the end of 2008, the Chinese State Council announced a massive fiscal stimulus package in an effort to bolster the Chinese economy in the face of the worldwide financial upheavals occurring at that time. A brief summary of the detail of this stimulus can be found here. Recent changes to the M&A financing rules promulgated by the CBRC represent a significant modernization of China’s financial system as well as providing another boost to the economy combined with the effects of the stimulus package.
The Guidelines replace the prohibition set out in the ‘General Principles of Loans’ CBRC guidance from 1996 which prevented PRC banks from advancing loans to domestic Chinese borrowers for the purpose of M&A investments by such borrower.
The Guidelines permit loans to be made for the purposes of the purchase of both the equity and the assets of a target company (although it is unclear at this stage whether the acquisition of minority interests is covered by the scope of the Guidelines).
The Guidelines appear to be applicable to existing ‘foreign invested enterprises’ (including wholly owned foreign companies and Sino-foreign joint ventures) (FIEs) although acquisitions by FIEs would also be subject to approval from various local regulatory bodies which may logistically delay or restrict the availability of funding to them (further clarifications should be provided on this issue by the relevant authorities).
In this regard, foreign private equity funds that have set up a RMB denominated fund in China appear particularly well positioned to benefit from the Guidelines and to leverage their investments in China.
The Guidelines also provide a mechanism for domestic Chinese companies to obtain funding for offshore investment. Previously it was extremely difficult for domestic Chinese companies to borrow money from Chinese banks for offshore acquisitions. As a result, to date, most offshore acquisitions have been made by China state owned companies. The Guidelines, by offering a new source of funding for overseas acquisitions to Chinese domestic companies, may, in the current market, result in an expansion of such acquisitions.
It should be noted that the Guidelines do not appear to contemplate the financing of new business operations or new joint ventures in China.
New business opportunities for subsidiaries of foreign banks in China
Under the Guidelines onshore Chinese commercial banks (including locally incorporated subsidiaries of foreign banks and joint-venture commercial banks, but not onshore branches of foreign banks) are now generally allowed to engage in M&A finance lending on the Chinese market, subject to certain rules and limitations.
One of the most important provisions of the Guidelines (and one which forms part of the strategic risk assessment of the whole M&A project that the lending bank is obliged to make) is that in deciding whether or not to make financing available, a commercial bank should consider ‘the industrial and strategic correlation between both parties’ and the ‘expected strategic effects and driving force for the increase of enterprise value after the M&A.’ This provision is doubtless intended as a credit control measure and to prevent commercial banks from providing finance to M&A projects with little discernible overall benefit (thereby presumably prohibiting acquisitions with asset-stripping motives). This may also prevent investment holding companies or private equity funds with a portfolio of diverse but unrelated holdings from obtaining finance in order to make an acquisition in a new sector. How strictly this position is interpreted will be crucial to determining the success of the Guidelines.
Commercial banks are required to have in place the procedures and personnel to perform thorough due diligence and a credit risk assessment on the parties to the proposed acquisition. This includes an analysis of the legal, compliance and regulatory risks, the strategic risks (such as the ability of the parties to successfully integrate) and of the operational and financial risks (such as reviewing cash flow and business models). For an overseas acquisition, commercial banks must consider factors such as exchange risks and applicable foreign country risks.
From a practical point of view, no specific approval is required for commercial banks to start providing M&A loans under the Guidelines. They just need to file a lending business plan and description of their internal risk control plan (including their ability to comply with these requirements and specific capital adequacy requirements) with the CBRC.
A step in the right direction towards a more sophisticated approach to acquisition finance
According to the Guidelines, specific provisions must be included in M&A loan documentation that should increase the sophistication of loan documents under Chinese law. For example, along with the requirement that borrowers should provide adequate security for a loan, the loan document must contain certain prescribed basic terms (such as mandatory pre-payment, change of control, restrictions on asset disposal and financial covenants) which would commonly already be found in most loan agreements in foreign jurisdictions.
The fact that the term of any loan is limited to 5 years and more importantly that the total value of a loan must not exceed 50 per cent of the total acquisition price (which reflects the cautious approach towards acquisition finance taken by the CRBC), paves the way for future reforms if the implementation of the Guidelines by commercial banks in China proves to be successful.
Gregory Louvel, Associate
Jonathan Keats, Associate
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Rules on overseas investments by Chinese companies
In recent years, overseas investment by Chinese companies has increased dramatically. The total amount invested in 2008 was US$ 52.15 billion. According to some commentators it may exceed the amount of inward investment into China for the first time in 2009. The Chinese government is actively encouraging overseas investment in certain sectors, partly as a method of utilizing China’s huge foreign exchange reserves and more recently to take advantage of depressed share and commodity prices around the world.
The ‘Administration Measures on Outbound Investment’ (Measures) released by the Chinese Ministry of Commerce (MOFCOM) on 16 March 2009 (coming into force on 1 May 2009) reflect the continued policy trend of encouraging overseas investment, whilst at the same time increasing governmental control over larger investments. The Measures generally make the outbound investment approval process quicker, clearer and (for smaller investments) easier to comply with, but at the same time allow the government to retain control of the decision making process.
The Measures apply to greenfield and M&A investments and replace the previous MOFCOM regulation ‘The Provisions on the Review and Approval of Outbound Investment to Establish Enterprises’ dated 1 October 2004 (2004 Regulations). Under the 2004 Regulations, MOFCOM’s role was more limited than under the Measures and project, operational and technical approval for overseas investments lay with the National Development and Reform Commission (NDRC) or the State Council. Approval from these organs was often slow and lacking in transparency.
Under the 2004 Regulations, MOFCOM (at national or provincial level depending on the sensitivity of the project, size of investment and the type of industry involved) was principally concerned with the structure of the investment being made and considering Chinese policies on industrial investment in particular countries. It is predicted that under the Measures, 85 per cent of transactions will be subject to provincial MOFCOM approval. Provincial MOFCOM approval is generally quicker and easier to obtain than national MOFCOM approval.
The Measures substantially increase MOFCOM’s role in the approval process. The NDRC is also currently revising its Overseas Investment Projects Examination and Approval Administrative Measures published in 2004. It is thought that the NDRC will further increase the threshold of the projects requiring national NDRC approval and further delegate to the local NDRC.
New MOFCOM approval process
Under the Measures, MOFCOM must now take into account the size of and type of investments when deciding which level of MOFCOM must give approval as opposed to considering the country of the proposed investment and the industry type.
National level MOFCOM approval is required for the following categories of investments:
- in countries with no diplomatic relations with China;
- in certain countries or regions (MOFCOM guidance on which particular countries or regions come within this category is due to be issued in the future);
- any investments of over US$100 million;
- investments spread over multiple countries; or
- investments involving the establishment of offshore special purposes vehicles.
In considering approval for one of the above categories of investments, the national MOFCOM is required to consult with the relevant Chinese consulates in the country targeted for investment. The time limit (excluding the consular consultation) for national MOFCOM approval is 30 business days. If an investment project involves the energy or mineral sector, MOFCOM must also consult with, and take the advice of, the relevant Chinese industrial association or chamber of commerce. This requirement also applies to energy and mineral investments requiring provincial MOFCOM approval (see below).
Provincial level MOFCOM approval is required for the following categories of investments:
- amounts of more than US$10 million but below US$100 million;
- investments in the energy or mineral sector; or
- investments that also need to attract other domestic investors.
Provincial MOFCOM is not required to consult with the relevant overseas Chinese consulate except where the provincial MOFCOM thinks it appropriate to do so or where the investment is in the energy or mineral sector. The time limit (excluding consular consultation, if applicable) for provincial MOFCOM approval is 20 business days.
The real beneficiaries of the Measures are those Chinese investors making small overseas investments of under US$10 million (which do not also fall into any of the other categories listed above). For such investments, the Chinese investor needs only to file an application form (without much of the supporting evidence required for larger investments) to provincial MOFCOM. The review of such applications should then be completed in three business days, which is a significant improvement on the previous timescale for approving small investments.
If approval is rejected by any level of MOFCOM, written reasons must be given and the investor is permitted to apply for the decision to be reconsidered or apply to court for a review of the decision.
One further important distinction to note from the 2004 Regulations is that approval (which will be evidenced by an outward bound investment approval certificate issued by the relevant MOFCOM) will automatically expire after two years from the issue of the certificate if the outbound investment has not been completed.
Supporting evidence required
The Measures prescribe in detail what evidence should be submitted to national or provincial MOFCOM (assuming the investment is not less than US$10 million). This includes:
- standard corporate information from the investor and the overseas target;
- the source of the investment funds;
- project details;
- an analysis and assessment of the investment environment of the country receiving the investment; and
- a statement that national sovereignty, security, public interests, PRC laws, state to state relationships, international treaties and the prohibition on technology/goods export will not be affected.
If the investment is by way of an M&A deal then MOFCOM will require further information, including a risk management evaluation and plan. The requirements listed at (b) to (e) were not required to be submitted to MOFCOM under the 2004 Regulations. These extra requirements give MOFCOM more discretionary power than under the 2004 Regulations and seem to shift responsibility for certain matters from the NDRC to MOFCOM.
Another important factor to note is that the Measures envisage that the Chinese investors will be responsible for the commercial and technical feasibility of the projects, which are excluded from MOFCOM review.
Likely impact of the Measures
As with most Chinese laws and regulations, the impact of the Measures will depend on their practical implementation and operation by MOFCOM. Of particular concern is how the Measures will operate in conjunction with existing NDRC, State Administration of Foreign Exchange and (if relevant) State-Owned Asset Supervision and Administration Commission rules and regulations, some of which overlap with the Measures. MOFCOM is also going to publish guidance on the countries which should be targeted for overseas investment and co-operation together with those countries in which investments will require national MOFCOM approval.
As mentioned, it is believed that the NDRC regulations will be amended shortly, but in the meantime, investors face some uncertainty as to whether other approvals in addition to the revised MOFCOM approval will be required. Some comfort may be drawn from the fact that once the approval certificate is issued, the Measures state that the investor will enjoy the ‘supporting policies of the state.’ China has in recent years concluded many bilateral investment treaties with other countries - and the terms of such treaties will further affect the approval process, it is to be hoped in most cases, positively.
Overall the Measures have speeded up the approval process for all levels of overseas investment, most notably for smaller investments. This may encourage smaller state owned or private companies which may have previously found the regulatory requirements for overseas investments too burdensome. However, the increased level of some submission requirements for larger investments and the differing approval levels required for certain countries and (in particular) investments in the energy and mineral sector show that the Chinese authorities wish to retain a firm grip in shaping the destination and nature of overseas investments, especially those in the energy and mineral sectors.
Looking at the Measures together with various other recent amendments to PRC regulations (including the changes to lending rules promulgated by the Chinese Banking Regulatory Commission which make it easier for Chinese companies to borrow to fund overseas investments - further detail on which can be found here, it is obvious that China is pursuing a policy of relaxing various regulations to encourage Chinese companies to ‘go global.’
Wang Yi, Partner
Jonathan Keats, Associate
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Overview of China’s environmental laws
Environmental laws have been on the statute books in China since at least the 1980s. Until recently, however, enforcement of these laws has not been as active or rigorous as in other parts of the world. This is set to change in the light of new developments, and consequently investors into China - current and future investors - should from now on give serious attention to environmental factors when doing business in China.
Due to increasing public awareness of environmental issues and the strengthened commitment of the government to China’s international environmental obligations, environmental protection has now become a major theme of Chinese government policy. China has publicly pledged to reduce energy consumption per unit of gross domestic product by 20 per cent and pollution emissions by 10 per cent between 2006 and 2010.
To meet these targets, China has implemented a raft of new legislation, including the Circular Economy Promotion Law issued in November 2008 which intends to promote sustainable development in China by increasing recycling efficiency and reducing pollution emissions. In addition, the Chinese government has recently introduced stringent environmental rules regulating the emission of pollution across China. Since the first half of 2008, the government has begun taking strict action against polluters, and some of these actions have already had an impact on foreign investments in China.
This article briefly summarises the principles behind the PRC environmental laws and their enforcement, discusses environmental risks and factors for foreign investors to consider, and considers the direction that China may be taking as regards the protection of its environment.
Chinese environmental rules are embodied in a number of different areas: constitutional principles, national laws and regulations, ministry circulars, local governmental rulings, and a substantial number of environmental standards on environmental protection, natural resources and renewable energy development.
Chinese environmental rules are chiefly intended to prevent pollution damage resulting from liquid and solid waste, air pollution and hazardous noise. The most important laws regulating pollution prevention are the PRC Environmental Protection Law, the Air Pollution Prevention and Control Law, the Water Pollution Prevention and Control Law, the Solid Waste Law Prevention and Control Law, Regulations on the Safety Administration of Dangerous Chemicals and the PRC Environmental Impact Assessment Law.
In China, environmental rules and regulations are designed to follow three guiding principles:
- The first guiding principle is emissions control. Under this principle, the total volume of pollutants that are permitted to be emitted by enterprises within a prescribed geographical area (usually, a province) is determined by the PRC central government. The total emissions volume may vary from year to year, and depends on a number of factors including local economic development plans, types of pollutant, and local environmental conditions.
Local government is required to regulate pollution emissions according to the total volume set for its area by the PRC central government or the level of government superior to such local government. This centralised system of emissions control was set in place with the intention of preventing local government from approving new investment projects regardless of their impact on the environment. The effectiveness of this policy has to date been fairly patchy.
- The second guiding principle is environmental impact assessment. Under this principle, any proposed investment into new production plants or their expansion must first pass an environmental impact assessment. The assessment is administered by the PRC environmental protection authorities - namely, the Ministry of Environmental Protection and the relevant local environmental protections bureau (collectively, the EPA). The purpose of such assessment is to demonstrate that the proposed project will not have a material negative impact on the local environment.
A proposed investment project into China will not be approved by any government authority until an environmental impact assessment has been successfully completed. The assessment may well lead to construction or operational plans being amended to bring them into compliance with environmental standards. Any environmental protection facilities that are required by the authorities to be incorporated into a project must be designed and constructed at the same time as the principal investment project itself.
Following completion of construction, and within three months after operations commence, a project will be subject to inspection and final approval by the EPA .
- The third guiding principle is that the polluter pays. Under Chinese law, a polluter must pay for the waste that it generates. This principle is generally enforced under a licensed discharge system. In most developed provinces of east China, enterprises must apply for a pollutant discharge licence before discharging certain types of waste (especially waste water or solid chemical waste) into the environment. An enterprise may only discharge waste in accordance with the conditions set out in its discharge licence. These conditions normally stipulate the type of permitted waste, the maximum volume of permitted discharge, the density of the waste and discharge method, and any permitted hazardous components. A fee which is calculated on the basis of the discharge amount and density of the pollutants will be payable to the EPA.
The PRC environmental regulator - EPA
The PRC environmental rules are chiefly enforced by the EPA, whose powers include investigating environmental accidents, inspecting and monitoring environmental compliance by businesses, issuing discharge licences and imposing administrative penalties for breach of environmental rules. Penalties may include suspension of construction or production pending rectification, and monetary fines.
The EPA regularly conducts investigations of projects that are under construction, and may then henceforth conduct annual site inspections. These activities will most likely lead to a course of correspondence between the EPA and the relevant business operation. It is important that a record is kept of any such correspondence.
From the first half of 2008, the EPA has begun taking a tougher stance against polluters. The number of investigations undertaken by the EPA has increased dramatically, and it has imposed a greater number of larger fines, particularly in the more industrialised regions of China. The ceiling for administrative fines for certain types of water pollution has more than doubled, and since January 2008 the penalty limit ( RMB 1 million) as set out in previous regulations has been removed. In addition, several of the largest state-owned enterprises that are in high pollution industries, including Sinopec and PetroChina, have been included on the EPA ‘watch list’, and are being closely monitored by the EPA to ensure their compliance with the environmental rules.
Environmental liability - administrative, civil and criminal
Chinese environmental laws impose three types of liability on polluters: (i) administrative liability, (ii) civil liability and (iii) criminal liability. Foreign invested enterprises (FIEs) are legal persons in China and accordingly FIEs and their management may be sued under Chinese law. Foreign investors, their FIEs and management should therefore be aware of their liability under PRC law.
Administrative liability is the most common type of liability incurred by polluters in China. The EPA is the authority that conducts investigations into alleged breaches of administrative rules. Administrative penalties may include a warning, fine, suspension or closing down of operations. There is no predetermined way of calculating administrative fines. The level of a fine will depend on the type and severity of the pollution, and the manner of non-compliance. A monetary fine may be set at between one and five times the waste discharge fee payable by the polluting entity - which may in theory amount to several million RMB. The EPA may also calculate administrative fines as a percentage of the total economic loss caused by the polluter.
If a polluter is an enterprise, its management may also be personally liable and administrative penalties may be imposed on them directly. For example, the EPA may impose fines on the management of companies that breach water pollution regulations of up to half their annual salary.
Civil law liability
Under civil law, a victim of environmental pollution (the Plaintiff) may sue the polluter and claim for compensation equal to the direct and indirect economic loss suffered by it. There is no punitive damages concept under PRC civil law in respect of environmental liability. Environmental pollution is treated as an action in tort under Chinese civil law. Disputes may be handled by the local EPA or the People's Court, as may be chosen by the parties involved.
The limitation period for bringing a claim under civil law against a polluter is three years from the time when the victim first knew or ought to have known about the matter giving rise to the claim. This period is longer than the two years limitation period set for normal civil cases.
Under Chinese law, (the Plaintiff does not need to prove the existence and breach of a duty. To be entitled to compensation under Chinese law, the Plaintiff must prove that the polluter caused the pollution and that the harm suffered by the Plaintiff is related to that type of pollution. If the Plaintiff succeeds in proving this, the burden of proof shifts to the polluter. It is therefore clearly most advisable for foreign investors to keep good up to date records on their environmental compliance in China.
Where pollution causes serious economic loss or personal injury, the person (intentionally or negligently) responsible for the accident may be held liable under Chinese criminal law.
Similar to administrative liability, a legal representative or any employee who ‘directly’ causes pollution may be held liable alongside the polluting enterprise. Note that there are no guidelines as to the definition of ‘directly’. Criminal liability for environmental accidents includes imprisonment of up to seven years and monetary fines.
Future types of liability
In addition to administrative, civil and criminal sanctions that may be imposed on polluters in China, the PRC government is in the process of introducing new powers to prevent and discourage enterprises from polluting the environment.
The EPA is exploring with other government departments including the Ministry of Commerce, the China Banking Regulatory Commission and the China Securities Regulatory Commission, whether to require environmental compliance as a condition to obtaining further or ongoing approval or assistance from those other regulatory branches of the PRC government. As a result, Chinese companies (including FIEs) which are sanctioned for breaching environmental laws may in future find that they cannot for instance obtain bank finance, raise funds on the stock market or further expand their business within China or overseas. Through this method of inter-departmental cooperation, it is intended that enterprises operating in China will be additionally incentivised to comply fully with PRC environmental laws.
Considerations for foreign investors
In addition to the environmental laws and framework discussed above, foreign investors need to consider the following factors when reviewing their current operations or considering acquiring new businesses in China.
Following the revision to the Guidance Catalogue for Foreign Investment (in November 2007) and recent changes in government policy, new foreign investment into any high pollution, high energy consumption or natural resources project is now prohibited or restricted. To date, such projects have generally related to heavy polluting industries such as steel, mining, cement and chemical and paper manufacturing, and have utilised outdated technology. The government is now keen to promote the adoption of new clean technologies into sectors of the economy that have historically been heavy emitters of pollution into the environment. Even existing foreign investment into these heavy polluting sectors may be curtailed in future. Expansion of operations may be prevented and existing preferential treatments may be suspended unless new environmental protection facilities or new production technologies are introduced to reduce pollution emissions.
Choice of project location
Since the total volume of pollution emissions is set and enforced by the government, a foreign investor must consider carefully the location of a proposed project. If some areas are close to reaching their aggregate total discharge volume, there may clearly be regulatory difficulties in constructing new operations which would result in further pollution emissions.
Compliance with environmental rules
Enforcement of environmental rules varies across China. Historically, local government departments in less developed areas of China have generally been willing to overlook or ignore mandatory environmental standards in order to attract investment. However, central government has started to take action against local governments and officials who fail to implement national rules and standards for environmental protection. As a direct result, many FIEs have been advised by their local government contacts that compliance with environmental rules which may have previously been lax, will in future be actively enforced.
Historical environmental liability
In any M&A deal, there is always a risk that a target company is later discovered to own polluted property. According to the polluter pays principle, the target company will be primarily liable to clean up any pollution and pay compensation to any third parties that have suffered loss as a result of such pollution. The cost to the company of paying the compensation and the clean-up costs may ultimately result in loss to the new shareholder of the target company.
Where polluted property has been acquired, the new owner may in principle seek redress against the previous owners in respect of any environmental liability borne by the new owner. Where however the relevant previous owner cannot be found or has ceased operations, PRC authorities may tend to rule against the existing owner of polluted property even where they were not responsible for the pollution or contamination. It is therefore advisable that any foreign investor planning to acquire assets in China should first conduct thorough environmental due diligence on any property in order to identify any outstanding or potential environmental liability.
The PRC government is increasingly using the media to ‘name and shame’ polluters in public. Official pronouncements are made in the press, notifying the public of administrative penalties imposed against polluters. Although administrative fines are not generally substantial, the reputational damage caused by this type of negative publicity is widely perceived to outweigh the economic incentive to disregard environmental rules.
The PRC government has begun to focus its energies on safeguarding the environment. Penalties are now being imposed, sanctions levied and offending parties named in public. Although current PRC environmental laws may not be as sophisticated or severe as elsewhere amongst developed countries, there is every expectation that within a reasonably short time frame - the next five years or so - a new enforcement regime will emerge across the country which will require the attention and compliance of all business operators in China.
Foreign investors should therefore give serious thought to environmental factors when planning future business strategies in China. They should also review their existing business operations. In many instances, current levels of profitability may in part be due to non-compliance with environmental rules. Whilst a relaxed state of affairs may continue in the immediate short-term, recent renewed and spirited interest in the environment at the grass roots of society and at the centre of government indicates that in future polluters will ignore PRC environmental rules at their peril.
The emergence of a robust environmental regime in China is taking place at the same time as fiscal and regulatory incentives are being introduced to encourage businesses to adopt greener working practices. The combined result is expected to present new opportunities to foreign investors who are keen to buy into the high-tech production methods of the next generation.
Thomas Fairley, Associate
Zhang Yue, Associate
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Shipbuilding in China
In November 2008 the PRC government announced a ( US$ 586 billion) stimulus package to support domestic industry and commerce affected by the global financial crisis. Central government funds account for approximately US$263 billion with the balance provided at the local and provincial government level and by state-owned and private enterprises, export credit agencies and commercial bank loans. A brief summary of the detail of this stimulus can be found here. China’s shipbuilding industry was identified as one of the Country’s “Ten Pillars of Industry” to benefit from financial aid and other economic incentives under the government’s stimulus package.
Stimulus plan for China’s shipbuilding industry
In early February 2009 China’s State Council adopted a stimulus plan for China’s shipbuilding industry. By supporting domestic shipbuilders, the PRC government will also support associated industries such as steel and chemical production, textile manufacture, light industry, equipment manufacture and IT . The first stage of the Stimulus Plan will introduce credit support for domestic purchasers of Chinese-made ocean-going vessels until 2012. Other policies include the provision of tax rebates on major imported components for domestically owned ocean-going vessels.
Objectives of the shipbuilding industry stimulus plan
The shipbuilding industry stimulus plan outlines various objectives, including:
- stabilizing production by encouraging the major domestic shipbuilders and shipowners to adhere to previously agreed newbuilding delivery schedules;
- stimulating domestic demand for newbuildings by scrapping and replacing older vessels;
- developing the offshore sector by encouraging domestic shipbuilders to invest in the construction of high-value and technologically advanced vessels such as oil rigs and other offshore equipment;
- consolidating the domestic shipbuilding industry by encouraging corporate reorganisation, mergers and acquisition among existing yards and the improvement of their corporate governance;
- promoting research and development in new shipbuilding and marine technology and encouraging domestic shipbuilders to upgrade existing production technology; and
- expanding scope of business services and market share by encourage domestic shipbuilders to enhance their ship repair services and expand their vessel product range, specialized vessel construction and manufacture of offshore equipment.
The PRC government has set out various measures to promote the development of the domestic shipbuilding industry to reach the objectives set out in the stimulus plan.
Firstly, domestic banks will provide credit support to domestic shipbuilders affected by delayed orders and increase provision of refund guarantees (to support the domestic shipyards) and performance guarantees (to support domestic shipowners) in order to kick-start new orders. Additional financial incentives will also include the provision of construction mortgages and other investment products and shipbuilding industry-related bonds and investment funds, although the details have not yet been published.
Secondly, financial support will be provided to domestic shipowners and leasing companies who step in and perform shipbuilding contracts that would otherwise have been cancelled by the original buyers.
Thirdly, the PRC government has agreed to provide VAT tax refunds to domestic shipbuilders for the sale of oil rigs and other offshore equipment to Chinese oil and natural gas exploration companies, to increase government department budgets for the acquisition of government-owned vessels and to implement new regulations on the scrapping of older vessels and single hull tankers.
Lastly, the wording of the stimulus plan would suggest that domestic yard construction and development under the existing 10 year “Shipbuilding Industry Development Plan” (which commenced in 2006 and covers the building of new docks and the expansion of existing slipways), be suspended for 3 years.
Credit support for foreign buyers and our business
Whilst the Stimulus Plan does not directly benefit foreign shipowners, domestic banks (and export credit agencies) are encouraged to provide increased buyer’s credit schemes for foreign buyers in order to promote the construction and sale of vessels for the export market. Norton Rose advises domestic export credit agencies, policy and commercial banks on both plain vanilla and complex ECA -backed or tax-based leasing shipping finance transactions for both newbuilding and second-hand vessels. As a result, we have seen a fairly immediately increase in activity this sector.
From our review of recent term sheets produced by the domestic ship finance banks, it is evident that these banks have begun to provide substantial financial support to both Chinese and foreign shipowners in order to acquire vessels under construction in China or in circumstances where vessels will go on fixed term charter to domestic operators. In addition to plain vanilla finance, we have begun to see other forms of support in the shipping sector. For example, China’s export credit insurer, Sinosure, now provides leasing scheme insurance policies to cover payment risk for charterhire earnings, among other export credit-based insurance products.
Jonathan Silver, Associate
Nigel Ward - Now in Beijing
Shipping finance forms an important part of our broader banking and finance practice in China. The practice has recently been strengthened by the arrival of Nigel Ward in our Beijing office. Nigel is a senior banking partner who has relocated from our office in Paris. He has considerable experience working on shipping finance matters.
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Registration of mortgages over ships under construction
The concept of ship construction mortgage was recognized in China’s Maritime Code in 1993 but until very recently regulations for the registration of construction mortgages existed in only three provinces. This changed on 9 June 2009, the China Maritime Safety Administration (the MSA) issued the Interim Measures on the Registration of Mortgages over Ships under Construction (the Measures). The Measures, which came into effect on 9 June 2009, describe the conditions and procedures for the registration of mortgages over ships under construction.
Mortgages over ships under construction must be registered at the MSA Bureau of the jurisdiction where the shipbuilder is domiciled.
Under the Measures, in order to register a mortgage over a ship under construction, the following conditions must be satisfied:
- the mortgagor must be a qualified shipbuilding enterprise;
- the mortgagee must be a financial institution capable of making loans;
- the mortgagor must independently own the ship under construction;
- if the ship is built in accordance with the hull block construction method, at least one block must be completed and the construction must be ongoing; if the ship is built in accordance with the integral shipbuilding method, the ship’s keel must be laid out and the construction must be ongoing;
- the value of the ship under construction must be assessed by a qualified asset valuation institution and the assessment report must be confirmed in writing by the mortgagor and the mortgagee;
- the value of the obligation secured by the mortgage does not exceed the assessed value of the ship under construction; and
- there are no legal or regulatory obstacles preventing the creation of the mortgage.
The Measures list the documents which must be provided in support to the registration application. These documents include the Shipbuilding Contract, the Mortgage Agreement and the agreement creating the obligation secured by the mortgage. Other documents which must be provided include at least five different pictures of the ship under construction evidencing the status of the construction and authenticated by a ship inspection institution.
After receiving an application for the registration of ownership title and mortgage rights, the MSA Bureau will assess the consistency and authenticity of the information provided by the applicant as well as the application’s compliance with the Measures and the PRC Ship Registration Provisions (effective since 1 January 1995).
If at the time of the registration application the assessed value of the ship under construction is below the value of the obligation secured by the mortgage, the MSA Bureau shall register the mortgage up to the assessed value of the ship under construction.
If the assessed value of the ship under construction exceeds the value of the obligation secured by mortgage and if a separate mortgage is created on this excess value, the MSA Bureau may perform the registration of this second mortgage. If the assessed value of the ship under construction increases in the course of the construction and a new mortgage is created on this new value, the MSA Bureau may perform the registration of this new mortgage.
Before delivery of a newly constructed ship over which a mortgage has been created, the mortgagor and the mortgagee must apply to the MSA Bureau to release the mortgage.
Upon completion of the construction of a new ship, the ship-owner seeking the registration of its ownership title over the new ship must provide the MSA Bureau with a detailed summary, as well as evidence, of the registration and releases of mortgages over the ship.
The Measures are unlikely to be assistance to foreign parties. Currently their applicability is restricted to securing loans by state-owned financial institutions to selected yards in China.
Jim James, Partner
Charles Desmeules, Associate
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PRC Anti-Money Laundering Laws
Money laundering is the practice of disguising illegally obtained funds so that they seem legal. It is a well-known fact that money laundering is prevalent throughout China. In order to tackle this issue, the PRC Anti-Money Laundering Law (the Law) was introduced and came into effect on 1 January 2007. The Law aims to prevent money laundering activities which attempt to conceal or disguise, by any means, the sources of proceeds generated from criminal activities, including drug-related crimes, organised crimes, terrorist crimes, smuggling, corruption, bribery or financial fraud. The Law and the PRC Criminal Law form the basic legal framework for the prevention, monitoring, regulation, investigation and punishment of money laundering activities in China.
Prior to 1 January 2007, anti-money laundering obligations were only imposed on banks and financial institutions. Since the Law came into effect on 1 January 2007, anti-money laundering obligations are also imposed on non-financial institutions.
This article provides an overview of the anti-money laundering obligations of financial institutions in China, how investigations are carried out by PRC government bodies and the legal consequences of breaching the Law. The application of the Law to non-financial institutions is not considered in this article.
Financial institutions and non-financial institutions
According to the Law, the term “financial institutions” refers to PRC-incorporated policy banks, commercial banks, insurance companies, securities companies, futures brokerage companies and any other institutions that have been authorised by the administrative department of anti-money laundering of the State Council to engage in financial undertakings.
The Law and its related rules or regulations currently do not contain any provisions which stipulate the types of institution which fall within the category of “non-financial institutions”.
Anti-money laundering obligations of financial institutions
A financial institution must implement certain measures to fulfil its anti-money laundering obligations under the Law and its related rules and regulations. The main measures are set out below.
Establish a designated anti-money laundering department
A financial institution must establish a special department or designate an existing internal department to handle anti-money laundering matters.
Establish a client identity identification system
A financial institution must establish a client identity identification system to identify and verify the identity of any client who wishes to become a client of the financial institution.
Retain records of documentation
A financial institution must retain records of a client’s identification documents and transaction documents (including any account books) for a period of time. The duration of such period of time varies depending on the type of industry to which the financial institution belongs.
Establish an internal control system
A financial institution must establish an internal control system, formulate internal operating procedures and control measures for the purposes of preventing potential money-laundering activities and monitoring compliance with the anti-money laundering obligations of financial institutions under the Law.
Report large-sum transactions
A financial institution must report to the relevant authority any transaction involving a large sum of money in Renminbi or a foreign currency.
Report suspicious transactions
If a financial institution reasonably suspects that the assets involved in any transaction are connected with a crime, it must submit a written report to the local branch of the People’s Bank of China and the local public security bureau.
Provide training to employees
A financial institution must provide training to its employees in relation to the anti-money laundering obligations of financial institutions under the Law.
If the People’s Bank of China or (as the case may be) its branch department at the relevant provincial level suspects that a financial institution is involved in money laundering activities, it may conduct an investigation on such financial institution. During the course of an investigation, the relevant personnel at the financial institution may be interrogated. The investigators conducting the investigation may review and make copies of materials related to the financial institution or person(s) under investigation. Furthermore, client accounts which are relevant to the investigation may be temporarily frozen.
Legal consequences of a breach of the Law
If a financial institution in China breaches its anti-money laundering obligations under the Law, the relevant PRC government authority has the right to order the financial institution to cure the breaches within a limited period of time. In serious cases, a fine of up to RMB 5 million may be imposed upon the financial institution and fines of up to RMB 500,000 may be imposed upon directors, senior managers and any other persons responsible for the breach. In addition, the relevant PRC government authority has the right to order the financial institution to:
- impose a disciplinary sanction on its directors, senior managers and any other persons responsible for the breach;
- disqualify them from their current positions; or
- prohibit them from working in the financial industry sector.
In exceptionally severe circumstances, the government authorities may order the financial institution to suspend its business operations while rectifying the breach or revoke its business licence.
Tan Hwee Lynn, Associate
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China employment - calculation of severance pay
The PRC Employment Contract Law (ECL) came into effect on 1 January 2008. Under the ECL, the method of calculation of severance pay is complex. This article aims to clarify the legal position today in the light of both the ECL and the applicable PRC laws and regulations in effect prior to that date (Previous Rules).
Entitlement to severance pay
Before the ECL came into effect, the Previous Rules provided that employees were entitled to severance pay in any of the five following circumstances:
- the employee and employer mutually agree to terminate the employment contract through negotiations;
- the employer terminates the employment contract because, after a period of medical care for an illness or non-work-related injury of the employee, the employee still cannot engage in the work he/she was engaged in prior to the illness or injury, or any other work assigned to him/her by the employer after the illness or injury;
- the employer terminates the employment contract because the employee is incompetent and remains incompetent after training is provided to the employee or an adjustment is made to the employee’s work position;
- the employer terminates the employment contract as a result of a significant change in the circumstances relied on at the time of conclusion of the employment contract, which results in the employer and/or the employee being unable to perform the employment contract and, after negotiation, the employer and the employee fail to reach agreement on amendments to the employment contract; or
- there is a mass lay-off of employees and the employer terminates the employment contract in accordance with applicable PRC laws and regulations.
The ECL introduced more circumstances where employees are entitled to severance pay. In addition to the five situations where employees are entitled to severance pay under the Previous Rules, employees are now also entitled to severance pay in any of the following circumstances:
- the employee terminates the employment contract because the employer fails to implement the labour protection or work safety measures specified under PRC law or the employment contract;
- the employee terminates the employment contract because the employer fails to pay the employee his/her remuneration in full and by the due date;
- the employee terminates the employment contract because the employer fails to pay the relevant statutory social insurance premiums for the employee;
- the employee terminates the employment contract because the employer has implemented rules and regulations that infringe applicable PRC laws or regulations, which also infringe the employee’s rights or interests;
- the employer uses deception or coercion, or takes advantage of the employee’s difficulties, to cause the employee to conclude an employment contract, or to make an amendment thereto, contrary to his/her true intent;
- the term of the employment contract expires (provided that, if the employer wishes to renew the employment contract and the conditions offered by the employer are the same as, or better than, those stipulated in that contract, and the employee refuses to renew the employment contract, then no severance pay is payable to the employee);
- the employment contract is terminated because the employer is declared bankrupt;
- the employment contract is terminated because the employer’s business license is revoked, the employer is ordered to close down its business or to dissolve its corporate entity, or the employer decides to liquidate its business before the expiration of the period of operation stated in its business licence; or
- other circumstances as may be stipulated in applicable PRC laws or regulations.
Calculation of severance pay
Under the ECL, severance pay is calculated based on:
- the average monthly pay of the employee during the previous 12 months immediately prior to the termination of the employment contract; and
- the length of service of the employee with the employer.
The employee is entitled to receive one month’s pay for each completed year of service, subject to a maximum of 12 months pay. An employee who has served less than one full year but more than six months is deemed to have served one year. An employee whose length of service with the employer is less than six months is entitled to severance pay of half of one month’s pay.
If an employee’s average monthly pay exceeds three times the specified average monthly pay for the city where he or she was employed, then in calculating severance pay the employee’s monthly pay is assumed to be capped at three times the specified average monthly pay in respect of any employment period (Three Times Cap Rule) from 1 January 2008, the date on which the ECL took effect. The Three Times Cap Rule was introduced by the ECL and only applies to employment periods after 1 January 2008.
There is no equivalent cap in the previous Rules. However, under the Previous Rules, severance pay was capped at 12 times the actual average monthly pay (12 Months Cap Rule) in two circumstances, namely where the employment is terminated upon agreement and where the employment is terminated because the employee cannot engage in the work he/she was engaged in prior to illness or injury.
How is severance pay calculated in respect of an employment contract which came into effect before 1 January 2008 (the implementation date of the ECL) but which is terminated after 1 January 2008? The severance pay for the period before 1 January 2008 is calculated in accordance with the Previous Rules, and the severance pay for the period after 1 January 2008 is calculated in accordance with the ECL and any applicable regulations.
However, there is no agreed approach as to how to calculate the average monthly pay for each period and how to apply the 12 Months Cap Rule. The approach may vary from one location to another.
In Shanghai, the Shanghai High Court and Shanghai Municipal Human Resources and Social Security Bureau issued the Several Opinions on the Application of the Employment Contract Law (Shanghai Opinions) in March 2009. The Shanghai Opinions provide guidance as to the proper method of calculating severance pay. According to the Shanghai Opinions, the average monthly pay, which forms the basis for the calculation of the employee’s severance pay, for periods before 1 January 2008 and after 1 January 2008, should be the average monthly pay of the employee during the 12 months immediately preceding the termination of the employment contract.
If an employment contract is terminated under any of the two situations where the 12 Months Cap Rule applies under the Previous Rules (namely where the employment is terminated upon agreement and where the employment is terminated because the employee cannot engage in the work he/she was engaged in prior to illness or injury), the employee is only entitled to severance pay up to the amount of the 12 Months Cap Rule, regardless of whether the aggregate years of service before and after 1 January 2008 exceed 12 years.
For example, if the period of employment of an employee is 15 years before 1 January 2008 and 1 year after 1 January 2008 (i.e. 16 years in total), and the employer and the employee agree to terminate the employment contract through negotiations, according to the Shanghai Opinions, the employee is only entitled to severance pay up to the amount of the 12 Months Cap Rule, even though he/she has worked for the employer for 16 years.
Nie Qian, Associate
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Hong Kong’s Civil Justice Reform
On 2 April 2009 the long awaited and much talked about Civil Justice Reform (CJR) came into force in Hong Kong. The CJR seeks to initiate a complete change in approach and attitude towards litigation. It is hoped that this will result in an even more efficient procedural system that reduces delay and expense and enables parties to achieve just resolutions of their disputes.
The fundamental change in approach and attitude will be carried through and reflected in all stages of the litigation process. Below are some of the changes that you should know about.
The six underlying objectives of the CJR are to:
- increase cost effectiveness;
- deal with cases expeditiously;
- promote a sense of proportion;
- ensure fairness between the parties;
- facilitate the settlement of disputes; and
- ensure the fair distribution of the courts’ resources.
The courts are obliged to take into account and give effect to these objectives. Amongst other things, we expect to see the courts taking a greater control over litigation proceedings to help ensure that orders are complied with and only necessary applications are made. In doing this, the courts will recognise that it is important to have a sense of proportionality in relation to the economies of a case.
A revamped litigation process
The underlying objectives are common themes which underpin all key areas of the reform and will be reflected in all stages of the litigation process. For example:
Active case management
A key area of change is the new case management system, which imposes obligations on the courts and provides them with wide-ranging powers to manage the flow of civil litigation. The new case management system involves:
- Timetable directions and case management conferences: Generally speaking, early on in the litigation process the parties will file timetabling questionnaires with the courts proposing deadlines for the key stages in the litigation process (e.g. discovery and the exchange of witness statements). Where the parties reach agreement on the proposed timetable, the court may adopt their suggestions without the need for the parties to attend court. Where the parties fail to reach agreement in relation to the proposed timetable, or if the courts think necessary, a case management conference will be convened.
- In addition to setting timetable directions at the case management conference, which it is hoped will help to secure the timely progression of the case, the courts may, amongst other things, review the steps which parties have taken in the preparation of the case, ensure that all admissions that can be made and all agreements that can be reached are made and recorded, and ascertain any attempts by the parties to settle the matter or any intentions to undergo alternative forms of dispute resolution. As an added layer to ensuring that a matter efficiently progresses to trial, the courts are able to adjourn the case management conference to a later date or to hold pre-trial reviews to ensure that the parties are complying with all timetable directions set.
- The dates for the case management conference, the pre-trial review and the trial date (or trial period) are labelled ‘milestone dates’, which are effectively immovable and, accordingly, should deter parties from engaging in tactical litigation to delay matters. All other dates will be known as ‘non-milestone dates’. We expect to see greater intervention by the courts and stricter controls over directions and orders made including harsher sanctions where a party fails to comply with any such orders.
- Streamlining and cost cutting procedures: Through case management conferences and pre-trial reviews, the courts are to encourage the parties to co-operate and identify issues which warrant full investigation at the trial, and to summarily dispose of those which do not. To help the parties identify issues at an early stage in the litigation process, the parties are no longer able to include in their pleadings a blanket denial of a matter in issue. Rather, any such denials need to be supported by reason.
- Where practical, parties may be excused from attending court on pretrial applications to help save time and money. This feature should be particularly helpful in multi-party claims where a lot of time is spent trying to match the parties’ schedules.
- Encouragement of settlements: A key aim of the CJR is to encourage parties to cooperate and to settle their disputes as quickly and as economically as possible. The courts will, therefore, prompt parties to consider alternative dispute resolution mechanisms, such as mediation, where appropriate. Contrasted with civil trials which are mostly open to the public, mediation allows the parties to resolve their differences in a confidential and private setting. In mediation, the mediator is a neutral third party who plays a facilitating role and helps the parties explore each others’ positions and to discuss alternative bases upon which to settle the matter. The parties are free to decide the terms of any settlement and the mediator does not make any binding determination. The courts may view parties who do not attempt to settle matters and/or to actively participate in alternative forms of dispute resolution unfavourably and those parties may face adverse costs orders being made against them.
The courts have the power to order parties to the dispute, as well as third parties, to disclose documents which are “directly relevant” to the issues in dispute (i.e. those documents that would likely be relied on by the parties at trial or affect the parties’ positions) to each other before the commencement of court proceedings.
There are additional reforms in relation to discovery aimed at streamlining the litigation process.
Statements of truth
All pleadings, witness statements and witness reports now have to be verified by statements of truth. A statement of truth provides that, to the best of the deponent’s knowledge, the content of the document is true. Parties need to be careful before making statements of truth and should not assert speculative claims in pleadings which cannot be supported by evidence. If the content is found to be false, the deponent may be held guilty of contempt of court and face fines and imprisonment. It is hoped that a side effect of this new requirement will be to do away with lengthy repetition and any bolstering of claims so that parties may focus on the key and relevant issues.
Under the CJR, a defendant may admit a claim where money is sought and propose payment terms for the plaintiff’s consideration. Generally speaking, an admission of this nature entitles the plaintiff to enter judgment against the defendant on the basis of the admission. Where the plaintiff does not accept the defendant’s proposed payment terms, the courts have the power to assess the defendant’s proposal and to subsequently incorporate it into a court order if appropriate, or to make an alternative order as to payment terms without the need for a hearing. The desired effect is to resolve debt recovery matters in a straightforward and economic fashion.
Sanctioned offers and payments
As already noted, under the CJR the courts are to help facilitate the settlement of disputes. Under the old rules, a defendant was able to make a payment into court of an amount it would be prepared to pay to settle the dispute. If the plaintiff rejected the offer but was awarded a lesser sum at trial, the plaintiff would be at risk of an adverse costs order being made against it. The CJR has extended this right to plaintiffs and accordingly, puts defendants at risk as to costs if they reject sensible offers to settle from plaintiffs. Parties are, therefore, given an incentive to reach agreement as soon as practicable. This should help to minimise any unnecessary tactical moves and, in turn, reduce legal costs.
Under the CJR, Judges and Masters generally have a wider discretion in relation to costs awards then they previously had and are entitled to take into account, amongst other things, the underlying objectives of the CJR and the conduct of the parties including pre action behaviour.
Another aspect of the CJR is that the courts may now make costs orders against third parties “in the interests of justice”. This power is to be used primarily against those third parties who fund litigation and who stand to gain if the litigant they are funding wins but who are not currently liable to pay costs where that party loses. In upholding the underlying objective of ensuring fairness between the parties, the courts may also make costs orders against third parties who drive legal actions which have little chance of success.
In developing the CJR, Hong Kong has considered and drawn from the experiences of a number of other civil justice systems including England, Canada, Australia, New Zealand and the United States. The CJR has introduced changes that will hopefully make civil litigation more accessible and cost effective. Through a streamlined process and greater court intervention, it is hoped that the CJR will encourage a commercial approach towards litigation including a sense of proportionality, the elimination of steps and applications that are unmerited, unnecessary and wasteful, and an even playing field.
A consequence of the CJR will likely be a greater frontloading of legal costs as lawyers have to prepare most of the evidence relating to a case at an early stage and the parties need to prepare all the information relating to the case as soon as possible, so that the lawyers can promptly present their case to the court. As parties will now know each others’ positions at an early stage and will be encouraged to cooperate throughout the process, it is hoped that more matters will settle prior to proceeding to trial, the duration of trials will be shortened and that parties will save costs in the long run.
The effectiveness of the new regime will be enhanced by a willingness on behalf of the parties to embrace the changes and, in many respects, will hinge upon the courts’ role of enforcing the new rules and procedures.
Norton Rose Hong Kong’s Dispute Resolution team has experience in all forms of dispute resolution including negotiation, mediation, arbitration and commercial litigation. The team offers training on the new procedural rules.
Jim James, Partner
Ruth Cowley, Partner
Natalie Caton, Associate
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