What Regulatory Trends Are Impacting China Mergers and Acquisitions?

China is currently witnessing a series of regulatory trends that restricts the scope of certain types of M&A deals. A spate of new antitrust, national security, and data security regulations have resulted in extra reviews from the government or even the collapse of deals. Finally, the government’s position on engineering a green transition in the economy is making ESG practices a major consideration in the due diligence leading up to M&A negotiations.

The last three years have seen relatively new regulatory trends hugely impact the mergers and acquisitions (M&A) market. Among others, data compliance and environmental, social, and corporate governance (ESG) factors have become important considerations at all stages of the investment and value creation process, while antitrust and national security reviews are becoming more commonplace in M&A deals.

Besides, policy imperatives of the Chinese government have triggered crackdowns on several high-margin business sectors, including big tech companies, the for-profit tutoring industry, gaming services provided to minors, and the medical beauty industry. Naturally, these have cooled down M&A transactions in affected markets.

In the next few sections, we summarize some of the major regulatory trends affecting M&A transactions in recent years and explore how dealmakers can prepare in advance.

Data compliance considerations in M&A

With China ramping up legislative efforts in cybersecurity and data protection, data compliance requirements are becoming more relevant for businesses, posing new challenges for M&A dealmaking.

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Parties to a deal are now paying close attention to the data compliance of the target enterprise, especially for those whose data assets account for a high proportion of their total asset value or are of high importance to the company. The parties should also ensure that data provision activities in the whole M&A due diligence process comply with relevant data compliance requirements. In addition, there are some compliance considerations for the after-deal data transfer.

Data compliance due diligence of the target enterprise

Data compliance due diligence has become a common process in M&A transactions in the European Union and the United States, while China is closely following this trend.

Based on the risks exposed in the process, data compliance due diligence may affect the valuation of the targeted assets and the design of the transaction structure, and lead to the termination of the transaction in certain circumstances. Thus, data compliance due diligence is of vital importance to both parties.

For the seller, preparing for the data compliance due diligence in advance can give them an upper hand in the M&A deal. Rather than wait for data compliance issues to be flagged by the acquirer, the seller is advised to conduct data compliance audits regularly or prior to a potential M&A deal, either in-house or through a professional third party, to identify problems and gap areas and make targeted improvements in time. Through this process, the valuation of the target enterprise/seller’s underlying equity or data assets will be increased and the certainty of the potential M&A transaction will be improved. The seller can also use data compliance as a selling point to attract more high-quality buyers.

For the buyer, failure to properly conduct data compliance due diligence and identify potential risks may result in business losses or other consequences after the transaction is completed. The buyer is advised to conduct comprehensive and in-depth data compliance due diligence to ensure the safety of M&A transactions. Based on the findings of the data compliance due diligence, the buyer may decide to:

• adjust the deal price;
• divest problematic data assets or set pre-closing covenants in transaction documents; or
• terminate the deal if the potential risks are too big.

While all industries are subject to cybersecurity and data laws, data compliance is more important in certain industries than others, including:

• Industries that take data as core production factors or assets (e.g., artificial intelligence, autonomous driving, big data analysis, cloud services, intelligent security, )
• Industries that operate on a large amount of personal information (e.g., e-commerce, retail, tourism, express delivery, hotels, aviation, education, medical care, )
• Key information infrastructure operation industries (e.g., energy, transportation, finance, municipal services, e-government, )

Only when both parties jointly pay enough attention to data compliance, can the rights of both parties be better protected, and the intention behind pursuing the M&A be achieved.

Data compliance in the due diligence process

In the process of M&A due diligence, the buyer needs to know the seller’s information, including equity/ assets, business, staff, intellectual property, finance, and so on. To satisfy the buyer’s requirements, the seller shall provide such information and related data to the buyer and the buyer’s external consultants. This process is often accompanied by the disclosure and transmission of a large amount of data.

However, under the current legal framework of data compliance, not all information can be provided to the buyer by the seller’s own decision. Among others, the seller shall be especially cautious about the information disclosure under the following three circumstances:

• When disclosing information listed in the “important data” catalogue by respective national, regional, or industrial authorities or the information that belongs to ‘core data’.
• When disclosing the personal information of the Chinese.
• When transferring data to overseas.

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Although many specific rules, such as the scope of national core data are yet to be introduced or clarified, it is suggested that all involved parties pay due attention and communicate with the relevant authorities in charge during the transaction process.

Also, both parties should sign data processing agreements and take necessary measures to ensure the security of the data disclosed or transferred from the seller to the buyer or the buyer’s external consultants.

After-deal data management

 Depending on the M&A transaction structure, the buyer’s data compliance liability is slightly different. In equity acquisition, the buyer buys the equity of the target company and becomes its shareholder. Generally, the relevant data assets are still in the name of the target company and the buyer does not hold them directly. As a shareholder, the buyer may be indirectly liable for data compliance issues. In an asset acquisition, the buyer becomes the owner of the data asset after completion. As the controller of the data asset, the buyer is directly responsible for the compliance risk of the data asset.

Moreover, Article 22 of the Personal Information Protection Law (PIPL) clearly stipulates that where a personal information processor needs to transfer personal information due to merger, division, dissolution, or declaration of bankruptcy, etc.,  it shall inform the individual concerned of the name and contact information of the recipient.

The recipient shall continue to fulfill its obligations as a personal information processor. Where the recipient changes the original purpose and method of processing, it shall obtain the consent of the individual concerned anew in accordance with the PIPL.

Therefore, in the case of business adjustment or cross-department data sharing after the completion of the M&A deal, if the promised purpose of data collected has been changed, special consent of relevant individuals shall be obtained before data transfer.

ESG in M&A

ESG stands for environmental, social, and governance – which represents the three main criteria for investors to quantify and evaluate a company’s level of sustainability.

With China’s ambitious carbon goals and its determination to transition to a green, low-carbon, and circular economy, ESG has grown to be a positive indicator for the long-term revenue growth of businesses in the country. M&A deals are thus looking at ESG concerns more than ever.

Though only 11 percent of the surveyed M&A executives said they extensively assess ESG in their deal-making process on a regular basis, 65 percent expected their company’s focus on ESG to increase, according to Bain & Company’s Global M&A Report 2022.

ESG linked to corporate strategy

It’s expected that more M&A deals will be ESG-motivated, meaning that the buyer turns to M&A  to advance their own ESG agenda.

For example, businesses in the energy sector may seek to transition to renewable energy sources to help them meet carbon reduction requirements and expectations of investors through M&A transactions, which is faster than building capacities from scratch. ESG also drives M&A in consumer markets for its value in helping the business improve its brand image and appeal to green consumption preferences.

ESG due diligence in M&A

Meanwhile, ESG-related due diligence on the target company is gaining popularity among conscious M&A buyers.

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In certain industries where there are comparatively high ESG compliance requirements (production, energy, R&D, etc.), failure to effectively spot ESG gap areas of the target company may lead to additional corrective and management costs or even attract administrative penalties, thereby affecting the deal value of the transaction. For example, the buyer may need to bear the cost of integrating and advancing the target’s ESG capabilities to its standards.

Accordingly, the buyer should communicate with their external consultants about the scope and depth of ESG due diligence based on the situation of the target company.

On the other hand, the seller may seek to increase the deal value and attract high-quality buyers by actively planning for ESG due diligence. This will require the cooperation of multiple departments of the company. If the company does not have internal professionals who are proficient in relevant laws and ESG management practices in specific industries, it is suggested to seek external assistance from ESG lawyers or third-party consultants.

Antitrust review in M&A

The completion of the M&A deal is subject to a series of legal and governmental regulatory conditions, the most important of which is the antitrust review.

With China stepping up its efforts to curb the disorderly expansion of capital from the end of 2020, the antitrust review has become increasingly stringent, impacting the scope of M&A transactions.

The antitrust review in M&A transactions comes under the “anti-monopoly declaration on the concentration of undertakings (经营者集中反垄断申报)” as stipulated in China’s Anti-Monopoly Law.

Accordingly, where the M&A deal has attained the standard for which a declaration is required to be made pursuant to the stipulation of the State Council, the relevant party shall make a declaration to the anti-monopoly enforcement agency of the State Council (the anti-monopoly enforcement agency) in advance.

Upon receiving the declaration, the anti-monopoly enforcement agency shall examine the M&A deal and decide whether to prohibit the deal within a stipulated period. The transaction shall not be made prior to the declaration or during the examination period.

M&A transactions in violation of these antitrust provisions could be stopped by the anti-monopoly enforcement agency. Deals that have been completed might be ordered to dispose of shares or assets or transfer business within a stipulated period or adopt other necessary measures to restore the pre-deal state. Moreover, monetary penalties shall be imposed on such antitrust violations.

The anti-monopoly enforcement agency refers to the State Anti-Monopoly Bureau, a deputy ministerial-level unit elevated from the anti-monopoly department of the State Administration of Market Supervision in November 2021. The higher-ranking authority is intended to strengthen supervision and anti-monopoly law enforcement and assist antitrust investigators to receive resources when investigating M&A transactions.

Even prior to the establishment of the State Anti-Monopoly Bureau, repercussions of the failure to make the anti-monopoly declaration on the concentration of undertakings had already intensified. In 2021 alone, the anti-monopoly law enforcement agency issued 107 fines for such violations, eight times that in 2020.

While the initial anti-monopoly crackdowns focused on platform companies, enforcement has been expanded to other traditional industries. It has been reported that the anti-monopoly bureau has begun sending letters of investigation to companies in traditional industries, based on tip-offs and other clues, to verify M&A transactions that are suspected of not being declared in accordance with the law.

Most recently, in late June 2022, China passed the Amendment to the Anti-Monopoly Law and released six revised drafts supporting rules that govern antitrust enforcement. Once implemented, the scope of M&A transactions that are subject to antitrust reviews shall be significantly expanded and the penalties for not complying with the antitrust provisions shall be increased.

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Currently, to trigger the antitrust review, both parties in the M&A deal must have annual revenue in mainland China of over RMB 400 million (approx. US$60 million), among other standards. The proposed draft seeks to lower this threshold to RMB 100 million (approx.US$15 million) and just one party reaching this threshold can lead to an antitrust review. This means that more M&A deals would be subject to antitrust review even if the target company is small.

As for penalties, the revised Anti-Monopoly Law has increased the maximum fines on the illegal concentration of undertakings from the previous RMB 500,000 (US$75,000) to:

• 10 percent of the sales amount of the preceding year against the undertaking on top of other corrective measures, where the concentration has the effect of eliminating or restricting competition; or
• RMB 5 million (US$750,000), where the concentration has no effect of eliminating or restricting

The increased damage is expected to make M&A dealmakers more conscious of the imperative of antitrust reviews.

All the above-mentioned trends demonstrate China’s determination in eliminating unfair competition, with the country striving to narrow the wealth gap among various groups. Under this circumstance, the antitrust review is expected to be highly relevant to M&A transactions in China for a long time.

Enterprises involved in M&A transactions should increase their knowledge of antitrust review compliance and hire professional anti-monopoly lawyers to evaluate whether the transaction needs to be declared – as early as possible. If both parties know that the M&A deal will be subject to an antitrust review, they will be better prepared, including in strategizing how to negotiate the deal price, deal structure, other considerations, etc.

National security review in M&A

National security review, or security review, is another legal procedure that impacts whether the M&A deal can be successfully completed or not. Different from the first three regulatory trends introduced above, which affect both foreign and domestic M&A, the national security review only happens in foreign M&A transactions.

On January 1, 2020, the Foreign Investment Law came into force and established the foreign investment security review system. This applies when “a foreign investor acquires shares, equities, property shares or any other similar rights and interests of an enterprise within the territory of China”, that is, foreign M&A. Then in December of the same year, the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM) released the Measures for Security Review of Foreign Investments (the Security Review Measures), which further clarified the type of foreign investments to be subject to security review, the institutions, the scope and procedures of security review, as well as how to deal with unlawful investment activities.

The national security review on foreign M&A transactions is, however, not recent. It has been in existence since the 2010s when the matter was subject to the following regulations:

• 2009: Provisions on Foreign-funded Mergers and Acquisitions of Domestic Enterprises;
• 2011: Provisions of Ministry of Commerce on Implementation of Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (MOFCOM Announcement [2011] No. 53); and
• 2015: Notice of the General Office of State Council on Promulgation of the Trial Measures on National Security Review for Foreign Investments in Pilot Free Trade Zones (Guo Ban Fa [2015] 24).

The Foreign Investment Law and the Security Review Measures integrated and consolidated the rules scattered in multiple regulatory provisions.

According to the Security Review Measures, for foreign investments (including foreign M&A transactions) that affect or may affect national security, foreign investors or the relevant parties in China should take the initiative to make the declaration to the authority in charge prior to making the investments. The authority in charge here refers to the ‘Office of the Working Mechanism for the Security Review of Foreign Investments (office of the working mechanism) under the NDRC.

Foreign investments within the following categories are subject to security reviews:

• Category I: Investments in the military industry, investments in the supporting industries of the military industry and other fields relating to the security of national defense, and investments in areas surrounding military facilities and military industry
• Category II: Investments in other important fields relating to national security (e.g., important agricultural products, important energy and resources, important equipment manufacturing, important infrastructure, important transport services, important cultural products and services, important information technology and Internet products and services, important financial services, and key technologies, etc.), where the foreign investors obtain the actual controlling stake in the investee enterprise.

For Category II, while the Security Review Measures enumerate multiple important fields, it provides no guidance on how to determine whether the investments are “important” or not.

Meanwhile, while the Security Review Measures lists three circumstances where foreign investors are regarded as “obtaining the actual controlling stake”, it lacks specific standards on determining whether the foreign investors have a “significant impact” on the investee company. Such issues shall be subject to the discretion of the office of the working mechanism before more detailed rules are released.

With China increasingly improving foreign investor access and leveling the playground for domestic and foreign players, the government sees the foreign investment security review system as an important tool in preventing risks and safeguarding national security. That’s why relevant rules on the security review of foreign investment are so stringent, leaving no room for foreign investors to circumvent national security reviews by designing the structure or form of the deal for this purpose.

According to the Security Review Measures, for foreign investment falling into the scope but failed to declare, the office of the working mechanism has the right to order relevant parties to dispose of their equity or assets within a specified time and take other necessary measures to restore the state before the investment is implemented, and this right has no time limit.
For a transaction that should be declared, the investment will be in an uncertain state for a long time if it is not reported as required, even if the deal seems to have been completed for the moment.

In view of this, we suggest that the relevant parties pay attention to this regulatory trend and plan for and actively handle the relevant procedures for the foreign investment security review. Amid the growing geopolitical tensions faced by the Chinese economy, it can be anticipated that the enforcement of security review will be strengthened, and the foreign investment security review will become more imperative for foreign M&A.

Looking forward

Based on current trends, we expect that antitrust, national security, ESG, and data security concerns will continue to impact the process, structure, and even results of M&A transactions. It is more important than ever for dealmakers to integrate these considerations in their M&A strategy planning and risk management.
Foreign investors who plan to access China’s emerging opportunities through M&A are advised to pay close attention to the market and regulatory trends in this dynamic regime.

(This article was originally published in China Briefing magazine China M&A Outlook: Trends and Strategies in July 2022.)

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