How Chinese Laws Regulate Tender Offers for the Stock of Public Companies

Xiaowen QIU

Perspectives, Vol. 3, No. 1

I. Introduction

In China, the most important law regulating tender offers is the Securities Law, which was promulgated in December 1998 and took effect in July 1999 (hereinafter "PRC Securities Law"). China's other laws governing corporate activities - the Company Law, the Equity Joint Venture Law, the Cooperative Enterprise Law, and the Wholly Foreign-Owned Enterprise Law - also greatly affect tender offers in China. Because China's laws, especially the PRC Securities Law, bear many similarities to the United States Securities Laws and laws concerning corporate governance, and because the United States has already developed a comprehensive legal system regulating tender offers, I first provide an introduction to the U.S. legal system regulating tender offers; second, I introduce and evaluate China's legal regime regulating tender offers, with a view towards comparing the two legal regimes. Then I compare the PRC Securities Law with the former 1993 Securities Regulation of China, which had been the law regulating securities before the PRC Securities Law came into existence. I finally offer some conclusions.

II. An Introduction to the U.S. Legal Regime Regulating Tender Offers

There are a variety of methods of acquiring a public company in the U.S.. One way is through a merger agreement, which often involves getting the approval of the target's shareholders. Another way is an asset deal, in which the acquirer buys substantially all of the assets of the target. An acquirer may also choose to deal with shareholders one at a time in an attempt to purchase a controlling share of the stocks of the target. When there are a limited number of shareholders, the acquirer can negotiate and reach agreements with each of them individually. For public companies with widely dispersed ownership, however, individual negotiations are not practical and the acquirer thus often makes a public offer to the shareholders to purchase their stocks. This type of offer is known as a tender offer. A tender offer in a negotiated or friendly context is quite different from a tender offer in a hostile context. In both China and the U.S., an acquisition by tender offer is in essence a means of buying a substantial portion of the outstanding stock of a company by making an offer to purchase all shares, up to a specified number, tendered by shareholders, within a specified period, at a fixed price, usually at a premium above the market price.

1. The Williams Act: the 1968 Amendment to the 1934 Exchange Act

In the United States, the main federal legal regime regulating securities activities consists of the Securities Act of 1933 (the "1933 Securities Act"), and the Securities Exchange Act of 1934 (the "1934 Exchange Act"). The 1933 Securities Act regulates initial distributions of securities by providing that, unless otherwise exempted, all initial distributions of securities must be registered with the Securities and Exchange Commission (hereinafter "SEC"). The 1934 Exchange Act regulates secondary trading of securities by regulating the markets in which they trade, protecting buyers and sellers of publicly traded securities. It provides the public with current information through the filing of periodic reports with SEC and regulates disclosures to security holders when proxies are solicited for annual or special meetings, when tender offers are made, or when issuers repurchase securities. The antifraud provisions of the 1934 Exchange Act protect against materially misleading disclosures and manipulative and deceptive trading practices to prevent adverse effect on investors.

Prior to 1967, cash tender offers were essentially unregulated and there were very few such transactions. In 1968, Congress passed the Williams Act as an amendment to the 1934 Exchange Act. Congress further amended the 1934 Exchange Act in 1970. In 1998, the SEC issued a release to amend the regulation of takeovers and security holder communications. The amendment became effective on January 24, 2000. Now, all cash tender offers are subject to the Williams Act. Tender offers with securities as consideration, that is, exchange offers, are subject to both the Williams Act and the 1933 Securities Act.

1) Section 13 of the 1934 Exchange Act: An early warning system

According to Section 13 of the Williams Act, a person must file a Schedule 13D within 10 days after becoming beneficial owner of 5% or more of any equity security registered under section 12 of the 1934 Exchange Act. Schedule 13D requires disclosure of the following information: 1) the background, identity, residence, and citizenship of, and the nature of such beneficial ownership by such person, and all other persons by whom or on whose behalf the purchase has been or is to be effected; 2) the source and amount of the funds or other consideration used or to be used in making the purchase; 3) the purpose of the purchases or prospective purchases; 4) the number of shares of such security which are beneficially owned, and the number of shares concerning which there is a right to acquire, directly or indirectly; 5) information as to any contracts, arrangements, or understandings with any person with respect to any securities of the issuer.

If there are any changes in the information reported in the previous filing of Schedule 13D, such person has to promptly file or cause to be filed with SEC an amendment to the Schedule 13D disclosing such change. An increase or decrease of one percent or more in a person's beneficial ownership is deemed by the SEC to be a material change.

2) Section 14 of the 1934 Exchange Act: Disclosure of Tender Offers

One of the important features of the Williams Act is to require prior notice of the bidder's desire to acquire shares, which not only makes it possible for all shareholders to tender on a pro rata basis, but also alerts the whole marketplace that the bid is ongoing, thus opening the way for competitive bids. As soon as practicable on the date of the commencement of the tender offer period, the bidder must: a) file with the SEC a Tender Offer Statement on a Schedule TO; b) deliver a copy thereof to the target company and to any other bidder which has filed a Schedule TO that has not terminated for the same class of securities of the target company; and c) give telephonic notice of specified information concerning the offer and mail a copy of the Schedule TO to each relevant national securities exchange. Rule 14e-2 to the 1934 Exchange Act obligates the target company to disclose its management position on the tender offer and the reasons for that position and to update any material changes in such previous disclosure.

A bidder will have commenced its tender offer at 12:01 am on the date when the bidder has first published, sent or given the means to tender to security holders. The means to tender includes the transmitted form or a statement regarding how the transmittal form may be obtained.

Rule 14d-4(b) exempts exchange offers from the registration requirements of the 1933 Act. Thus an exchange offer may commence once a registration statement has been filed with SEC even though the registration has not become effective.

Rule 14e-1(a) requires that a tender offer remain open for at least 20 business days following commencement of the tender offer. Furthermore, Rule 14e-1(b) requires a tender offer to remain open for 10 business days after notice to security holders of an increase or decrease in the percentage of the class of securities being sought, the consideration offered or the dealer's solicitation fees.

Section 14(d)(5) of 1934 Exchange Act provides that securities deposited pursuant to a tender offer may be withdrawn at any time until the expiration of seven days after commencement of the tender offer. Section 14(d)(5) must be read in conjunction with section 14(d)(6), which modified section 14(d)(5) to require that if a bidder makes a partial offer, then the pro rata rule must operate for a minimum of 10 days. Thus for a partial bid, the offer must remain open for a minimum of ten calendar days.

Section 14(d)(7) of the 1934 Exchange Act is the "best price rule," which requires bidders to pay any consideration increased before the expiration to each security holder whose securities are taken up and paid for pursuant to the tender offer.

Under Rule 14e-5, once a bidder has made a tender offer, he may not buy shares other than through the tender offer and all shares must be treated on an equal basis. Negotiations with particular shareholders are allowed only before the tender offer commences. The bidder may not make the tender offer to purchase the shares contingent on the success of the tender offer at a price other than the tender offer price. Rule 14e-5 protects investors by preventing an offeror from extending greater or different consideration to some shareholders outside the offer, while limiting other shareholders to the offer's terms. The Rule is applicable to both a cash tender offer and an exchange offer. It does not apply to a purchase or an agreement to purchase outside of a tender offer during a subsequent offering period if the consideration is the same in form and amount.

Finally, a bidder under Rule 14d-11 may use a subsequent offering period after the tender offer is closed to purchase additional shares for 3 to 20 business days. But again, the consideration must be the same as in the initial tender offers.

The Williams Act and its amendment are often irrelevant today because of so-called "poison pills." The poison pill is an innovative defensive tactic originally devised by a New York law firm. It has become one of the most popular techniques adopted by management of the target company. The basic purpose of a poison pill is to deter abusive takeover tactics by making them unacceptably expensive to the raider, and encouraging prospective acquirers to negotiate with the target company's management prior to the acquisition of a large block of the target's shares. In most cases the pill will enable target management to reinsert itself as the bargaining agent for target shares. If there is a tender offer to be made, the tender offer would have to apply the timing requirement of Williams Act in form. But in substance, in the poison pill era, poison pill determines the outcome of the bid. Nonetheless, the time regime is still important.

2. State Common Law: Delaware Law Regulating Fiduciary Duties in the Context of Tender Offers

The management of the target company often adopts defensive measures against tender offers. Under Delaware law, which is important because many large corporations are incorporated in Delaware, defensive measures must pass a two-prong test. First, target management must have reasonable grounds for believing that there is a danger to the target's welfare. Management and the board cannot act merely to perpetuate themselves in power. Second, the defense must be reasonable in relation to the threat posed. The response cannot be preclusive (one that makes it almost impossible for the hostile bid to succeed) or coercive (one that forces shareholders to accept management's own alternative to the hostile bid). The board must take the defensive measure not only in good faith, but only after reasonable investigation. In a close case, a court is more likely to approve a defensive measure if it is adopted by a board, the majority of which are disinterested directors. The target board does have the right to "just say no" when it receives an unsolicited offer. In other words, the board may refuse to approve the transaction or recommend it to shareholders, even if this has the effect of blocking the deal.

Once the company is put up for sale, new duties are triggered and the target board must create a "level playing field" and obtain the highest price for shareholders. The "level playing field" rule applies not only where target's management is selling the entire company, but also where the management has decided to sell control to a single individual or entity.

III. China's Securities Law: A Comparison with U.S. Law

China's securities markets came into being only a decade ago. A unique characteristic of the Chinese securities markets is that China classifies securities according to the legal status and nationality of the shareholders. Some classes of shares may not be freely traded on Chinese exchanges.

In 1992, the Chinese State Council created the Securities Commission of the State Council and its executive body, China's Securities Regulatory Commission ("CSRC"), to regulate the trading of securities. The CSRC is the counterpart of the SEC of the Untied States. The following year, China promulgated the Administration of the Issuing and Trading of Shares Interim Regulations ("the 1993 Regulations" or "the Regulations"). In 1999, the PRC Securities Law replaced the 1993 Regulations.

1. Disclosure of substantial ownership and substantial change of ownership

The PRC Securities Law provides that listed companies may be taken over by tender offer or by agreement. When an investor has acquired 5% of the issued shares of a listed company through securities exchange trading, he must, within three calendar days after the acquisition of the 5% stake, submit a written report to the CSRC and the stock exchange listing the stock, notify the listed company, and make a public announcement of this fact. During the three-day period, the investor may not trade any shares of the target company. Thereafter, the investor shall report and announce each 5% increase or decrease in the number of shares of the company he has acquired through securities trading on a stock exchange. The acquirer must stop trading in the target company shares during the reporting period and for two days following the report and the announcement. This is to prevent the acquirer from changing its ownership position until the market is aware of the acquirer's ownership position. What the investor has to report and announce is set forth in the PRC Securities Law: the name and domicile of the shareholder; the description and quantity of the shares held; and the date on which the shareholding or the increase or decrease in the shareholding reached the statutory percentage.

Under the Williams Act, an acquirer must make a similar level of disclosure to the target company shareholders, but the disclosure system in the U.S. is more sophisticated: First, in the U.S. an acquirer has 10 days rather than only 3 days to disclose. Second, in the U.S., an acquirer does not have to stop trading in the target company's securities after acquiring 5% beneficial ownership. Rule 16a-1(a) defines "beneficial owner" as any person who directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares a direct or indirect pecuniary interest in equity securities. The PRC Securities Law does not have the "beneficial ownership" concept, one reason being the less developed securities market and regulatory bodies in China.

Third, in the U.S., normally a 5% beneficial owner must file a Schedule 13D. But a broker or dealer can file a short form 13G instead of the more complex form 13D. China does not make such distinctions, one reason being that there are not as many sophisticated institutional investors and professionals in China.

Fourth and finally, in the U.S., although the acquirer must also update the Schedule 13D to include all material changes, a 1% change in ownership is presumed to be a material change and must be reported in the Amendment to the 13D. In China, an investor need only report each 5% increase or decrease in the number of target company shares owned.

2. Takeover by Tender Offer

Under the PRC Securities Law, when an investor has already acquired, through stock exchange trading, 30% of the issued shares of a listed company, and continues to acquire such shares, the investor must make a tender offer to all the shareholders of the listed company unless the CSRC exempts him from doing so. However, before making a tender offer, the purchaser must first submit a report on the tender offer to the CSRC and simultaneously a copy of the report to the stock exchange on which the target company's shares are listed. Within fifteen days after the submission of the above report, the purchaser must announce the tender offer.

The term of the tender offer may be no less than 30 days but no more than 60 days, during which term the offer is irrevocable. If the offeror wants to make any changes to the tender offer, he must submit a report to the CSRC and the relevant stock exchange and, if approved, make a public announcement of the changes. During the term of the tender offer, the purchaser is prohibited from purchasing or selling target company shares by any method or on any terms other than that prescribed in the tender offer.

If the purchaser, upon expiration of the tender offer, obtained not less than 75% of the total number of issued shares of the target company, the listing of the shares on the stock exchange of the company shall be terminated. If the purchaser, upon expiration of the tender offer, obtained not less than 90% of the total number of the issued shares of the target company, the remaining shareholders shall have the right to sell their shares on the same terms as offered in the tender offer, and the purchaser has the obligation to buy up all shares so tendered. This is to protect the remaining shareholders from being frozen out on terms less favorable than those in the tender offer.

The U.S. also has an "all holders rule" set forth in Rule 14d-10 promulgated under the 1934 Exchange Act. Rule 14d-10 requires any tender offer to be available to all holders of the designated class of securities. But the acquirer is not required to make a tender offer. In addition, Rule 14e-5 prohibits the bidder from purchasing other than through the tender offer from the announcement of the tender offer through the expiration of the offer.

Finally, in the U.S., a tender offer may be made at any time at any price decided by the bidder. For example, even a bidder with no shares in the target company may make a tender offer for the shares of the company, and, if he is successful in purchasing the shares, take over the company. But the PRC Securities Law and the1993 Regulations do not address the possibility of making a tender offer before an acquirer has obtained 30% ownership. Nor does any case address this possibility. Theoretically, there is nothing in the law forbidding such an offer. Some interpret the PRC Securities Law to allow this as long as the offer conforms to the provisions governing tender offers.

By making a tender offer before reaching the 30% threshold, the purchaser does not have to make reports to the CSRC and the relevant stock exchange, announce his tender offer, and stop purchasing shares for a few days upon each 5% change of ownership. In this way, the purchaser does not have to make successive reports or stop purchasing shares upon each 5% change, and therefore does not have to make purchases at successively higher prices each time after it files a report and makes the required announcement.

In the U.S., a bidder can purchase as many shares on the market as it can get during the 10-day reporting period after it has reached 5% beneficial ownership. In this way, the bidder does not have to suffer losses from the price increase resulting from the announcement of its purchase. In reality, however, this is often not so easily done because many corporations have implemented poison pills as a defensive tactic, forcing the bidder to halt its purchase and come to the target management to redeem the poison pill before it reaches the 10%, 20% or any other poison pill's triggering threshold. Because tender offers are far less common in China than in the U.S., and corporations and securities markets are relatively new economic phenomena, China's companies generally do not implement poison pills or any other defensive tactics. And there is no law regulating these tactics. Therefore, a bidder in China can freely purchase any amount of shares during the three-day reporting period after it has reached 5% ownership.

3. Other

In China, during the acquisition of a listed company, the shares in the acquired company held by the purchaser may not be transferred for six months following completion of the takeover. Where the takeover involves shares held by a state-authorized investment organization, the approval of the relevant authority must be obtained.

IV. An Attempt to Relax Regulation of Tender Offers: A Comparison of the PRC Securities Law and the 1993 Regulations

The PRC Securities Law represents an attempt to relax restrictions on the acquisition of publicly traded companies. In the past, "because the government worried that a surge of acquisition activities in the open market would cause speculation and fraud that the newly established CSRC would be ill-equipped to handle", acquisition activities were discouraged and strictly regulated under the 1993 Regulations. Since the promulgation of the 1993 Securities Regulation, no hostile tender offer takeover attempt has ever succeeded. Later, some advocated that company acquisitions are "normal market activities, which beef up a company's operations and improve the company's allocation of resources," and that a failed Stated-owned enterprise (SOE) acquired by another company is better than a bankrupt SOE depriving its employees of their employment.

The CSRC appears to have undergone a change of attitude towards acquisitions, which was clearly reflected in the PRC Securities Law. First, the Law eliminated the Regulation requirement that a natural person could not own more than 0.5% of the issued stock of a listed company. In the past, if an individual citizen's equity interest exceeded the 0.5% threshold, then the company had to acquire the excess shares with the CSRC's approval at a price that was the lower of the market price or the individual's original purchase price. So now a natural person has the same legal right as a legal person to take over a listed company through a tender offer.

Second, after reaching the 0.5% threshold, a purchaser may buy 5% of the shares of the company, instead of only 2%, after the three-day waiting period before his reporting and announcing duties are triggered. The corresponding reporting duty of the listed company is not as clear under the PRC Securities Law as it was under the 1993 Regulations. Article 60 of the 1993 Regulations explicitly required the listed company to report to the CSRC and securities exchanges when a 5% shareholder purchases or sells 2% of the outstanding shares. Now, according to article 62 of the PRC Securities Law, when there is "a relatively major change in the shareholding of a shareholder who holds not less than 5% of the company's shares," the listed company shall immediately submit an report on the details of such major change to the CSRC and the stock exchange, and make an announcement of the change. It can be assumed that the purchase or disposal of 5% of the outstanding shares of the company by a 5% security holder is a "relatively major change" and triggers the reporting duty of the listed company. However, whether a 2% change of shareholding triggers the reporting duty of the listed company is not very clear under the PRC Securities Law.

Third, though the PRC Securities Law still requires a 30% acquirer to make a tender offer to all shareholders, it allows purchasers to request an exemption from the CSRC.

Fourth, the 1993 Regulations stipulated that the price of a tender offer be the greater of the average market price during the 30 trading days prior to the commencement of the offer and the highest price paid by a purchaser in the twelve months preceding the commencement of the offer. The PRC Securities Law eliminates this restriction, although the price of and the report on the tender offer must still be submitted to the CSRC for prior approval.

Fifth and finally, the PRC Securities Law allows an acquirer to use its own stock as consideration while the 1993 Regulations allows payment in cash only.

V. Conclusion

The PRC Securities Law was created during the Asian financial crisis. It seeks to provide more protection to investors during a hostile acquisition attempt than the Williams Act does. According to the PRC Securities Law, a bidder in China must overcome more stringent legal obstacles than a similarly situated U.S. buyer. However, the still young and immature securities market and the generally less sophisticated securities regulatory bodies as compared to the U.S. may not provide as much protection to shareholders as the law is intended to provide. In the meantime, PRC Securities Law represents an attempt to relax tender offer regulation under the 1993 Regulations.

China's securities market is still young and its securities regulations still need improvement. Certain problems in China, such as the inefficient market, the illiquid securities market, insider trading, and price controls, greatly affect the development of the market and of the relevant law. China is still trying to solve these problems in order to achieve a fair and efficient securities market.

(The author is an attorney with Davis Polk & Wardwell in New York.)