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Playing the state assets as in-kind capital contributions;

merger, acquisition, division, bankruptcy
or dissolution of SOE; changes in
shareholding percentages in a non-listed

state asset game SOE; transfer of equity interests or shares

in non-listed SOEs; transfers, swaps and
auctions of state-owned assets; leases of
state-owned assets to non-SOEs; disposal
How to rig the process to achieve the right result of state assets in satisfaction of judgment or
determination of value of state assets

hot topic in China is the so-called arrangement. Local SASACs are now pushing involved in litigation; and others. The
diversification of capital of state- their better SOEs to go public in no small above apply not only to pure SOEs but any
owned enterprises (SOEs). This part in order to be able to achieve liquidity of entity in which there is any direct or
is nothing more than a politically government investments through the public indirect state ownership, including Sino-
correct euphemism for privatisation. It stock markets. foreign joint ventures in which an SOE or
essentially means that the Chinese The other key trend in the sale of state- SASAC holds a direct or indirect equity
government is looking to put for sale signs on owned assets is M&A activity, both domestic interest.
state-owned enterprises (SOEs) all across and cross-border, with share acquisitions now Under the relevant regulations, the basic
China. more popular than the old-style asset deal. process is as follows: the proposed
The State-owned Assets Supervision and While there are numerous hoops that foreign transferor in a transaction involving state
Administration Commission (SASAC) was acquirers must jump through to get a cross- assets engages a licensed valuation company
established in 2003 to act as the direct owner border deal done (see the December 2006 and the valuation company conducts
and administrator of SOEs across China. At and January 2007 issues of the IFLR), in- valuation and issues the report. Although
the time it was set up, central SASAC was bound M&A is quickly becoming the four valuation methodologies are
responsible for nearly 200 large-scale central- preferred investment vehicle for foreign recognised under the relevant regulations
level SOEs. According to recently announced players in China. (discounted earnings method, replacement
plans, SASAC intends to cut that number to Commendably, China has been quite keen cost method, current market price method
fewer than 100 central-level SOEs and to to avoid the whole-sale illicit transfer of and liquidation price method), in most
require all remaining central-level SOEs to valuable state assets into private hands as has cases local valuers will reflexively resort to
spin off all non-core assets. Each of the happened in Russia and and other economies some variation of the net asset value (NAV)
central-level SOEs has hundreds and in transition. From the early stages of or net book value (NBV) method.
sometimes thousands of direct and indirect economic reform, independent valuations of Prior to the introduction of the PREs, so
subsidiaries, and below the central level, at the state-owned assets were required before long as the price to be paid was not less
provincial and municipal levels, there are tens transfers could take place. In the last few than 90% of the statutory valuation result,
of thousands of local-level SOEs. That adds years, this requirement has been buttressed by the transaction could proceed. With the
up to a lot of potential targets for private the adoption of a public auction process advent of the PREs, the statutory valuation
investors. through the state-owned asset property rights is announced and in theory potential
Capital diversification takes many different exchanges (PREs). bidders have at least 20 days to indicate an
forms. In the days following the economic interest. If there is only one potential
opening up of China, state assets were Corruption and inefficiency bidder, or with special approval from
commonly contributed into greenfield Sino- Predictably, in practice, the state-asset SASAC (which typically is not available as
foreign joint ventures in an early form of asset valuation and PRE processes do not work as a practical matter), the parties can enter
acquisition. well as one would hope. In most cases it ends into a private agreement on the terms of the
Next came domestic and off-shore IPOs, up being a lot of work for the parties transfer subject to the above 90% rule. If
but the public float was typically limited to without affecting the fundamental terms of there is more than one potential bidder,
20-30% of the total share capital, and until legitimate transactions involving state assets, then a public auction has to be conducted,
recently the remaining state-owned shares in but in other cases the system is still subject and the winning bidder enters into a
listed companies were classified as non- to corrupt influences that subvert the very contract for the transfer of the state-owned
tradable legal person shares. Following recent purpose of the state asset valuation and equity interests or assets. The PRE issues a
share reforms for A-share companies in public auction system. certificate which is then presented to the
China, these so-called G-shares have been A wide range of transactions trigger the local bureau of the Ministry of Commerce
converted into restricted tradable shares valuation requirement: conversion of an (Mofcom) as part of the package of
which can be sold down in stages over a three- SOE into a limited liability company or application documents for approval to
year period in a controlled lock-up joint stock limited company; injection of complete the transaction.

Chinese pragmatism
“In some cases the system is still Of course, it never works this way in the real
world, and Chinese pragmatism wins out in
subject to corrupt influences that subvert almost every instance. Take the example of
the purchase by a foreign company of shares
the very purpose of the state asset in a non-listed SOE. In practice the parties
would agree the consideration for the shares
valuation and public auctions ” up front, and then the SOE seller would

38 IFLR/November 2007

engage the licensed valuation company. The
foreign buyer does not sit passively to the
side hoping for a favourable valuation result “The Chinese seller simply gives the
but actively works with the valuation firm to
make sure the correct (read “pre-agreed”)
statutory valuation firm the target number,
result is achieved. and this figure magically appears in the
In many cases it will be necessary to work
with the valuation firm to agree on the
valuation methodology and the assumptions
valuation report ”
to be input into the model in order to ensure
that the valuation result falls within the The Shanghai PRE, the Shanghai United memory involved apparent corrupt abuse of
desired parameters. To be safe, the foreign Assets and Equity Exchange (SUAEE), has a the state asset public auction system. In
buyer arranges for a draft report to be issued well-deserved reputation for being the most September 2006 Liangyu Chen, the
first to make sure the local valuation firm has rigid and most expensive PRE in China. In a Secretary of the Chinese Communist Party
not inadvertently (or worse yet, intentionally, recent transaction, the prospective transferor, (CCP) Shanghai Municipal Committee,
and possibly at the insistence of the seller a municipal-level SASAC entity from a member of the CCP Central Committee and
who is suffering seller’s remorse and wants to regional province, engaged SUAEE to the highest ranking Party official in
reopen the price negotiations) departed from conduct an international competitive bid Shanghai, was detained for investigation of
the prepared script. In these cases, more auction for a minority stake in a leading SOE misuse of funds, corruption, and other
heavy lifting is required to push the valuation directly held by the local SASAC entity. This violations of party discipline. Several other
firm to revise the draft report until the right was not a typical transaction in that there was high ranking officials in Shanghai were also
result is achieved. Then the final report is no pre-negotiated deal, but it was a true arrested in connection with the arrest of Mr.
submitted and the parties proceed as agreed. competitive bid auction. The seller had Chen.
In other cases, the Chinese seller simply selected SUAEE in the belief that SUAEE Also caught in the widely cast net of this
gives the statutory valuation firm the target would be able to conduct the auction process corruption probe were certain board
number, and this figure magically appears in in a more independent and professional members and senior executives of Shanghai
the valuation report. Either way, the manner, and the seller (as well as the bidders) Electric Group Company Limited (SEC
valuation process is almost never paid a very substantial fee for the privilege. Group) and its controlling shareholder
independent or disinterested. When the auction process elicited only two Shanghai Electric Corporation (SEC). Other
The PRE process is similarly managed by bids, both of which were seriously non- companies controlled by some of these
the parties, generally with the active conforming due to the highly officers and directors had benefited from
assistance of the PRE authorities. The parties non-commercial and inflexible terms in the illicit loans from the Shanghai Municipal
come to the PRE with their agreed deal and SUAEE standard contract, the seller simply Social Welfare Fund controlled by Mr. Chen.
conforming statutory valuation report, and discarded the SUAEE process and negotiated The reason that SEC and SEC Group
the PRE in most cases then posts the deal in directly with the preferred bidder using the were dragged into this scandal apparently
a manner which will ensure that there are no bidder’s form of agreement. When the arose from the fact that companies owned
competing bids, typically either by means of regional SASAC had a subsequent deal to go by these directors had obtained their shares
bidder qualification requirements that only through a PRE, it selected a different in SEC and later SEC Group through a
the intended buyer can satisfy or by posting regional PRE that was both less expensive rigged public auction process conducted by
the deal information in a manner which and more flexible. the Shanghai PRE. Although the entities
cannot be accessed in a timely manner by This example points up a few key lessons. controlled by these directors were newly
other member of the public as a practical First, not all PREs are created equal. Some established, under-capitalized, small-scale
matter. Then the parties proceed with the are more flexible than others. Second, parties private enterprises, they emerged as three of
negotiated deal as previously agreed. have a choice of PREs, so shop around. And only five successful bidders from among
It is not quite as painless as the foregoing third, if SASAC wants the deal bad enough, more than 100 interested parties in
description may suggest. There are additional they can control the PRE process to achieve connection with the auction of just over
application documents to be completed and the outcome they want. This means that 30% of the shares in SEC in March of
application fees to be paid. Most PREs will buyers should not always take the printed 2004. Many smelled a rat at the time, and
have a standard form agreement that they instructions and terms issued by the PRE at last year the trap was finally set and sprung.
will insist be used as a base for the transfer face value. If the SOE seller and SASAC are The moral of the story is that the state
contract. As one would suspect, this standard on side, then the PRE generally will have to asset transfer system is almost always
form of agreement is poorly drafted, fall in line eventually, even if the process is rigged. The good news is that for the most
incomplete and generally useless. Some PREs painful and time-consuming for both buyer part it is rigged in a manner which achieves
are more flexible than others, but in some and seller. an arms length market price in connection
cases you have no choice but to use the with otherwise legitimate transactions. The
standard form provided by the PRE and then The darker side bad news is that this pragmatic good result
append the real contract as an annex to the Although in the typical scenario the PRE comes at an otherwise unnecessary cost of
standard contract in the form of process is benignly frustrating, in some cases, additional time, process aggravation and
supplemental terms and provide that in case more commonly in connection with professional fees. The key is to know the
of conflict, the supplemental terms control, transactions involving private domestic game and play it as cleanly as possible to
thereby eviscerating the whole of the players, a darker side to the PRE process achieve the right result with as little
standard form contract. This is inelegant but emerges. A core element of the biggest aggravation as possible.
it works. corruption scandal in China in recent By Robert Lewis of Lovells, Beijing IFLR/November 2007 39