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Takeover Defenses Under PRC Law (Part I)*

Issue: June 2006

Keywords (click to search): captial markets public company SOEs state owned enterprises state controlled entity China Securities Regulatory Commission CSRC share segregation reform initiatives shareholding structure

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By Liu Fang

fangl@sullcrom.com

Website www.sullcrom.com

A longstanding dominant feature of the People's Republic of China's (PRC) stock market is that a listed company's share capital typically consists of both tradable and non-tradable shares. With a majority of non-tradable shares held by a state-owned controlling entity, a hostile or unsolicited takeover in the open market is practically impossible. However, following the introduction by the China Securities Regulatory Commission (CSRC) of the commonly named "share segregation reform initiatives" in 2005, which require holders of non-tradable shares to convert their shares into publicly tradable shares, it is expected that the floating and selling of non-tradable shares in the open market will increase, resulting in a more diverse shareholding structure for PRC listed companies.

Generally, a higher degree of diversification in a shareholder base would make a PRC listed company more vulnerable to hostile takeover threats. Therefore, to address this potential risk, a PRC listed company may consider adopting anti-takeover devices and defense mechanisms that are usually used in the United States and Europe (with necessary modifications), which may also be available under relevant PRC laws and regulations.

Prohibited defense actions

The Measures for the Administration of the Takeover of Listed Companies (Takeover Measures)(上市公司收购管理办法) promulgated by the CSRC in 2002, provide certain guidelines regarding the ability of a target company's management to develop defense mechanisms against unsolicited takeover bids. Pursuant to Article 33 of the Takeover Measures, strategies and measures taken by the directors, supervisors and senior management of a target company, in response to a takeover threat, may not impair the legal rights and interests of the target company and its shareholders. Moreover, after an acquirer has publicly announced its intention to take over a target company, Article 33 specifically prohibits the target company's board of directors from proposing the following types of defense actions:

i. issuing shares;

ii. issuing convertible bonds;

iii. repurchasing shares;

iv. amending the target company's articles of association;

v. entering into contracts that could have a material effect on the target company's assets, liabilities, interests or results of operations, except in the ordinary course of business, or

vi. disposing of, or purchasing major assets or changing the target company's principal business, except for changes to business or restructuring of assets carried out by the company experiencing severe financial difficulties.

However, if such actions are taken in the furtherance of pre-existing contracts or shareholders' resolutions, Article 33 further provides that the target company's board of directors is exempted from these prohibitions.

It is doubtful whether the prohibitions in Article 33 have any practical value because under the PRC Company Law (Company Law)(中华人民共和国公司法), most of these prohibitive actions are beyond the scope of management's authority and cannot be initiated without the approval of a shareholders' meeting. Although management is barred by Article 33 from convening a shareholders' meeting to consider such a prohibitive action, the controlling shareholder of a target company, who is typically also threatened by the unsolicited takeover bid (and therefore an ally of the incumbent management) may have the incentive to conduct such a meeting.

Under the Company Law, a shareholder with 10% or more ownership interest is entitled to call a special shareholders' meeting; a shareholder with 3% or more ownership interest is entitled to submit shareholder proposals for consideration by the shareholders' meeting. The controlling shareholder, who is presumably able to meet the required ownership thresholds in most cases, may call a special shareholders' meeting independently and/or propose defense actions for adoption by the shareholders' meeting.

Dual-class share structure

A company with a dual-class share structure means that it has two (or more) classes of shares with different voting rights attached to them. For example, a company may have both Class A and Class B shares, with Class A shareholders having 10 votes for each A-share they hold; and Class B shareholders having only one vote for each B-share they hold. Except for voting rights, the rights associated with the two classes of shares are otherwise the same. Even though the holders of a particular class of shares may not have a majority economic interest in the share capital of the company, a dual-class share structure allows holders of the class of shares with the highest voting rights to retain control of the company by virtue of their substantial voting power. Therefore, a dual-class share structure is considered to be a very effective defense device.

A dual-class share structure can be employed only if the law of the relevant jurisdiction permits a company to: (i) issue more than one class of shares and (ii) designate different voting rights for different classes of shares. Article 127 of the Company Law provides that the same class of shares should carry the same rights. This provision seems to imply that a PRC company may issue different classes of shares with different rights, as long as the same class of shares carries the same rights. However, it is unclear whether it is possible to have different voting rights for different classes. Article 104 of the Company Law provides that shareholders have one vote for each share, which may be interpreted as precluding any variation in voting rights for different classes. Therefore, a PRC company may not be able to adopt a dual-class share structure under current PRC law as an anti-takeover device.

* This is the first part in a series of bulletins to be published in future issues of China Law & Practice on takeover defenses under PRC law.