While foreign investment in some sectors of China’s healthcare market has been recently liberalised others remain restricted, and risky. Ingo Vinck, a German Attorney-at-Law at Taylor Wessing, outlines the general legal landscape for foreign investments in healthcare in China, examines some typical legal problems and highlights some recent legislative developments.
Foreign Investment Guidance Catalogue
In the latest revision of the Foreign Investment Guidance Catalogue, which took effect on 10th April, 2015, the number of prohibited and restricted industries has been reduced, as has the number of industries for which a Sino-foreign equity joint venture is mandatory.
In the healthcare industry, manufacturing of a number of pharmaceutical products now qualifies as an ‘encouraged’ project. This includes, for example, the production of new compound drugs or drugs with active ingredients, the development and production of new anti-carcinogenic drugs, new cardio-cerebrovascular drugs and new nervous system drugs. The production of new pharmaceutical formulations and new products by employing new technologies such as slow release, controlled release, targeting and percutaneous absorption are further examples of encouraged businesses. Nursing homes for the elderly, the disabled and children, as well as retirement homes, were added to the ‘encouraged’ category of industries, too.
However, foreign investments in medical institutions remains restricted to those in the form of a Sino-foreign joint venture. Only in the Shanghai Waigaoqiao free trade zone and in some Chinese cities which function as pilot projects are there special regulations permitting the establishment of wholly foreign-owned hospitals.
Operational licences and deal structure
Most Chinese healthcare enterprises have special administrative licences in order to legally operate their business. For example, companies manufacturing or distributing medical devices or pharmaceuticals need medical device or drug manufacturing or distribution licences issued by the China Food and Drug Administration (CFDA). Hospitals need a practice permit for medical institutions, granted by the provincial department of the Ministry of Health (MOH). Since these operational licences are a mandatory requirement for most healthcare-related business in China, and since they are difficult to obtain and to maintain, they are considered a major asset of domestic healthcare enterprises by foreign investors. These operational licences play an important role when legally structuring an investment in the Chinese healthcare sector.
From a legal perspective there are basically two possible approaches when investing in China, each having its specific advantages and disadvantages. The foreign investor can either establish a new company or acquire an existing Chinese business through mergers and acquisitions (M&A). Setting up an entirely new business takes more time than acquiring an existing business. For a greenfield project the investor first has to find and acquire appropriate land, then construct buildings, procure the required equipment and materials, obtain all operational licences and hire qualified staff before starting business operations. The advantage of this approach is that every step is projectable and more or less under the control of the investor.
In contrast, every M&A deal is threatened by a number of imponderable factors, even from the beginning – a due diligence investigation of the target company may reveal liability risks unacceptable to the foreign investor or the M&A negotiations may impede the acquisition.
If the investor intends to acquire an existing business instead of setting up a new company, there are basically two possible legal deal structures (which can be combined and modified): a share deal and an asset deal.
In a share deal, the foreign investor can simply buy equity interest (shares) or subscribe increased capital in the target company. This has the disadvantage that the target company might have accumulated liability risks (for example, tax liabilities or liability risks resulting from incompliant business operations). This applies in particular to enterprises that have been existing and operating for many years.
Alternatively the investor can acquire all individual assets pertaining to the targeted business (without the legal entity owning and operating these assets). All assets are transferred individually. The major legal advantage of an asset deal is that the foreign investor does not take over existing liability risks of the target company. The disadvantages are that an asset deal can be legally more complex and lengthy. Further, the transfer of assets triggers VAT, business tax, land VAT and other taxes which can increase the acquisition price.
Since in the healthcare sector many companies have special operational licences that are not transferable an asset deal is often not a feasible deal structure for an investment. As foreign investors are often particularly interested in these operational licences more M&A deals take the form of a share deal in the healthcare industry than in other industries.
Typical due diligence findings
The idea behind conducting due diligence is that this type of investigation contributes significantly to informed decision making by enhancing the amount and quality of information available to the investors. The scope of a due diligence investigation of a Chinese healthcare company normally covers, among others, legal, tax, financial and regulatory aspects such as operational licences and product registrations.
Many Chinese companies in the healthcare sector operate similar distribution models and have business practices that are customary in China but which create certain legal and economic risks from the perspective of foreign investors. Accordingly due diligence investigations of Chinese healthcare companies often reveal risks which are typical and representative for the Chinese healthcare sector. Due diligence investigations often uncover that there are liability risks resulting from incompliant business operations: some Chinese healthcare companies bribe officials to maintain relationships or to solve problems with authorities. It is also quite common that in connection with the distribution of pharmaceuticals or medical devices customers, doctors or intermediaries offer or receive bribes, gifts or kickbacks.
Legally this qualifies as a form of unfair competition (leading to the risk of administrative penalties) and constitutes a crime and, unlike other jurisdictions, Chinese criminal law not only regulates the criminal liability of individuals but also of the legal entity itself. This means that an acquisition in the form of a share deal is often threatened by administrative and criminal liability risks applying to both the management and the target company itself. This is particularly the case if the foreign investor or any of its affiliates has to observe the Foreign Corrupt Practices Act (FCPA), the UK Anti-bribery Act or similar legislation.
Furthermore, manufacturers of drugs or medical devices in China typically distribute part of their sales through freelancers, agents and intermediaries who work on a commission-only basis. It is also often the case that distribution is done through unregistered sales offices or by using unregistered (i.e. illegal) local warehouses. From the perspective of a foreign investor these practices appear non-transparent, difficult to control, unstable and risky.
Mandatory payment terms
If a foreign investor acquires a domestic Chinese company in the healthcare industry the transaction is governed by the Provisions on Foreign Investors’ Mergers with and Acquisition of Domestic Enterprises (M&A Regulations, 22nd June, 2009). These M&A Regulations play an important practical role for any foreign investment in China. They stipulate, among others, that many M&A transactions and the accompanying acquisition agreements are subject to examination and approval by the MOFCOM or its local branches.
They also stipulate a mandatory three-month payment period for the entire purchase price of a foreign investor’s acquisition of a domestic enterprise (from the date of issuance of the new business licence). Although it is legally possible to apply for an extension, so that 60 per cent of the purchase price is to be paid within six months and the full price within one year, this extension does not apply in practice. When structuring a China investment and drafting the acquisition agreements it is therefore worthwhile to always keep the mandatory three-month time period in mind.
New regulations for holding companies
On 28th October, 2015, the MOFCOM issued the Decision to Amend Some Rules and Normative Documents (Decision), with changes taking effect on the same day. The legislative intention of the Decision is to simplify the registered capital registration system for companies in China.
The Decision substantially lowers the capitalisation requirements for setting up foreign-invested holding companies in China. This is good news foreign investors who previously considered bundling their China business in a China holding company but were discouraged by the high capital requirements.
According to the Decision the previous minimum registered capital requirement of USD 30 million for establishing a foreign-invested China holding company has been abolished. In addition the previous mandatory time limit for full capital contribution has been repealed and a foreign-invested China holding company may now be established as a company limited by shares or as a limited liability company.
In future it will also become easier for medium-sized company groups to establish holding structures in China.
Ingo Vinck is a German Attorney-at-Law and a member of Taylor Wessing’s China Group. He advises German and international companies on their business activities and investment projects in China. He specialises in corporate, contract and real estate law. As an M&A lawyer, Ingo has advised clients on many M&A projects in the healthcare sector in China. Ingo is based in Taylor Wessing’s Beijing office.