THE CHINA COLUMN
Playing the
state asset game
How to rig the process to achieve the right result
A
hot topic in China is the so-called
diversification of capital of state-
owned enterprises (SOEs). This
is nothing more than a politically
correct euphemism for privatisation. It
essentially means that the Chinese
government is looking to put for sale signs on
state-owned enterprises (SOEs) all across
China.
The State-owned Assets Supervision and
Administration Commission (SASAC) was
established in 2003 to act as the direct owner
and administrator of SOEs across China. At
the time it was set up, central SASAC was
responsible for nearly 200 large-scale central-
level SOEs. According to recently announced
plans, SASAC intends to cut that number to
fewer than 100 central-level SOEs and to
require all remaining central-level SOEs to
spin off all non-core assets. Each of the
central-level SOEs has hundreds and
sometimes thousands of direct and indirect
subsidiaries, and below the central level, at the
provincial and municipal levels, there are tens
of thousands of local-level SOEs. That adds
up to a lot of potential targets for private
investors.
Capital diversification takes many different
forms. In the days following the economic
opening up of China, state assets were
commonly contributed into greenfield Sino-
foreign joint ventures in an early form of asset
acquisition.
Next came domestic and off-shore IPOs,
but the public float was typically limited to
20-30% of the total share capital, and until
recently the remaining state-owned shares in
listed companies were classified as non-
tradable legal person shares. Following recent
share reforms for A-share companies in
China, these so-called G-shares have been
converted into restricted tradable shares
which can be sold down in stages over a three-
year period in a controlled lock-up
“In some cases the system is still
subject to corrupt influences that subvert
the very purpose of the state asset
valuation and public auctions
38 IFLR/November 2007
arrangement. Local SASACs are now pushing
their better SOEs to go public in no small
part in order to be able to achieve liquidity of
government investments through the public
stock markets.
The other key trend in the sale of state-
owned assets is M&A activity, both domestic
and cross-border, with share acquisitions now
more popular than the old-style asset deal.
While there are numerous hoops that foreign
acquirers must jump through to get a cross-
border deal done (see the December 2006
and January 2007 issues of the IFLR), in-
bound M&A is quickly becoming the
preferred investment vehicle for foreign
players in China.
Commendably, China has been quite keen
to avoid the whole-sale illicit transfer of
valuable state assets into private hands as has
happened in Russia and and other economies
in transition. From the early stages of
economic reform, independent valuations of
state-owned assets were required before
transfers could take place. In the last few
years, this requirement has been buttressed by
the adoption of a public auction process
through the state-owned asset property rights
exchanges (PREs).
Corruption and inefficiency
Predictably, in practice, the state-asset
valuation and PRE processes do not work as
well as one would hope. In most cases it ends
up being a lot of work for the parties
without affecting the fundamental terms of
legitimate transactions involving state assets,
but in other cases the system is still subject
to corrupt influences that subvert the very
purpose of the state asset valuation and
public auction system.
A wide range of transactions trigger the
valuation requirement: conversion of an
SOE into a limited liability company or
joint stock limited company; injection of
” up front, and then the SOE seller would
state assets as in-kind capital contributions;
merger, acquisition, division, bankruptcy
or dissolution of SOE; changes in
shareholding percentages in a non-listed
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
of state assets in satisfaction of judgment or
determination of value of state assets
involved in litigation; and others. The
above apply not only to pure SOEs but any
entity in which there is any direct or
indirect state ownership, including Sino-
foreign joint ventures in which an SOE or
SASAC holds a direct or indirect equity
interest.
Under the relevant regulations, the basic
process is as follows: the proposed
transferor in a transaction involving state
assets engages a licensed valuation company
and the valuation company conducts
valuation and issues the report. Although
four valuation methodologies are
recognised under the relevant regulations
(discounted earnings method, replacement
cost method, current market price method
and liquidation price method), in most
cases local valuers will reflexively resort to
some variation of the net asset value (NAV)
or net book value (NBV) method.
Prior to the introduction of the PREs, so
long as the price to be paid was not less
than 90% of the statutory valuation result,
the transaction could proceed. With the
advent of the PREs, the statutory valuation
is announced and in theory potential
bidders have at least 20 days to indicate an
interest. If there is only one potential
bidder, or with special approval from
SASAC (which typically is not available as
a practical matter), the parties can enter
into a private agreement on the terms of the
transfer subject to the above 90% rule. If
there is more than one potential bidder,
then a public auction has to be conducted,
and the winning bidder enters into a
contract for the transfer of the state-owned
equity interests or assets. The PRE issues a
certificate which is then presented to the
local bureau of the Ministry of Commerce
(Mofcom) as part of the package of
application documents for approval to
complete the transaction.
Chinese pragmatism
Of course, it never works this way in the real
world, and Chinese pragmatism wins out in
almost every instance. Take the example of
the purchase by a foreign company of shares
in a non-listed SOE. In practice the parties
would agree the consideration for the shares
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 engage the licensed valuation company. The
foreign buyer does not sit passively to the
side hoping for a favourable valuation result
but actively works with the valuation firm to
make sure the correct (read “pre-agreed”)
result is achieved.
In many cases it will be necessary to work
with the valuation firm to agree on the
valuation methodology and the assumptions
to be input into the model in order to ensure
that the valuation result falls within the
desired parameters. To be safe, the foreign
buyer arranges for a draft report to be issued
first to make sure the local valuation firm has
not inadvertently (or worse yet, intentionally,
and possibly at the insistence of the seller
who is suffering seller’s remorse and wants to
reopen the price negotiations) departed from
the prepared script. In these cases, more
heavy lifting is required to push the valuation
firm to revise the draft report until the right
result is achieved. Then the final report is
submitted and the parties proceed as agreed.
In other cases, the Chinese seller simply
gives the statutory valuation firm the target
number, and this figure magically appears in
the valuation report. Either way, the
valuation process is almost never
independent or disinterested.
The PRE process is similarly managed by
the parties, generally with the active
assistance of the PRE authorities. The parties
come to the PRE with their agreed deal and
conforming statutory valuation report, and
the PRE in most cases then posts the deal in
a manner which will ensure that there are no
competing bids, typically either by means of
bidder qualification requirements that only
the intended buyer can satisfy or by posting
the deal information in a manner which
cannot be accessed in a timely manner by
other member of the public as a practical
matter. Then the parties proceed with the
negotiated deal as previously agreed.
It is not quite as painless as the foregoing
description may suggest. There are additional
application documents to be completed and
application fees to be paid. Most PREs will
have a standard form agreement that they
will insist be used as a base for the transfer
contract. As one would suspect, this standard
form of agreement is poorly drafted,
incomplete and generally useless. Some PREs
are more flexible than others, but in some
cases you have no choice but to use the
standard form provided by the PRE and then
append the real contract as an annex to the
standard contract in the form of
supplemental terms and provide that in case
of conflict, the supplemental terms control,
thereby eviscerating the whole of the
standard form contract. This is inelegant but
it works.
www.iflr.com
“The Chinese seller simply gives the
statutory valuation firm the target number,
and this figure magically appears in the
valuation report ”
The Shanghai PRE, the Shanghai United
Assets and Equity Exchange (SUAEE), has a
well-deserved reputation for being the most
rigid and most expensive PRE in China. In a
recent transaction, the prospective transferor,
a municipal-level SASAC entity from a
regional province, engaged SUAEE to
conduct an international competitive bid
auction for a minority stake in a leading SOE
directly held by the local SASAC entity. This
was not a typical transaction in that there was
no pre-negotiated deal, but it was a true
competitive bid auction. The seller had
selected SUAEE in the belief that SUAEE
would be able to conduct the auction process
in a more independent and professional
manner, and the seller (as well as the bidders)
paid a very substantial fee for the privilege.
When the auction process elicited only two
bids, both of which were seriously non-
conforming due to the highly
non-commercial and inflexible terms in the
SUAEE standard contract, the seller simply
discarded the SUAEE process and negotiated
directly with the preferred bidder using the
bidder’s form of agreement. When the
regional SASAC had a subsequent deal to go
through a PRE, it selected a different
regional PRE that was both less expensive
and more flexible.
This example points up a few key lessons.
First, not all PREs are created equal. Some
are more flexible than others. Second, parties
have a choice of PREs, so shop around. And
third, if SASAC wants the deal bad enough,
they can control the PRE process to achieve
the outcome they want. This means that
buyers should not always take the printed
instructions and terms issued by the PRE at
face value. If the SOE seller and SASAC are
on side, then the PRE generally will have to
fall in line eventually, even if the process is
painful and time-consuming for both buyer
and seller.
The darker side
Although in the typical scenario the PRE
process is benignly frustrating, in some cases,
more commonly in connection with
transactions involving private domestic
players, a darker side to the PRE process
emerges. A core element of the biggest
corruption scandal in China in recent
memory involved apparent corrupt abuse of
the state asset public auction system. In
September 2006 Liangyu Chen, the
Secretary of the Chinese Communist Party
(CCP) Shanghai Municipal Committee,
member of the CCP Central Committee and
the highest ranking Party official in
Shanghai, was detained for investigation of
misuse of funds, corruption, and other
violations of party discipline. Several other
high ranking officials in Shanghai were also
arrested in connection with the arrest of Mr.
Chen.
Also caught in the widely cast net of this
corruption probe were certain board
members and senior executives of Shanghai
Electric Group Company Limited (SEC
Group) and its controlling shareholder
Shanghai Electric Corporation (SEC). Other
companies controlled by some of these
officers and directors had benefited from
illicit loans from the Shanghai Municipal
Social Welfare Fund controlled by Mr. Chen.
The reason that SEC and SEC Group
were dragged into this scandal apparently
arose from the fact that companies owned
by these directors had obtained their shares
in SEC and later SEC Group through a
rigged public auction process conducted by
the Shanghai PRE. Although the entities
controlled by these directors were newly
established, under-capitalized, small-scale
private enterprises, they emerged as three of
only five successful bidders from among
more than 100 interested parties in
connection with the auction of just over
30% of the shares in SEC in March of
2004. Many smelled a rat at the time, and
last year the trap was finally set and sprung.
The moral of the story is that the state
asset transfer system is almost always
rigged. The good news is that for the most
part it is rigged in a manner which achieves
an arms length market price in connection
with otherwise legitimate transactions. The
bad news is that this pragmatic good result
comes at an otherwise unnecessary cost of
additional time, process aggravation and
professional fees. The key is to know the
game and play it as cleanly as possible to
achieve the right result with as little
aggravation as possible.
By Robert Lewis of Lovells, Beijing
IFLR/November 2007 39