Shifting into Higher Gear

Anthony Lin

Corporate Counsel

04-25-2011

Sun Yanchen, legal director for state-owned BAIC, China's fifth-largest carmaker, has been a critical player in the company's hunt for the foreign whole-car technology it hopes will help it speed past domestic rivals.

This article first appeared in Corporate Counsel

It was March 2009, and U.S. automakers were on their knees. Federal bailout money had just started working its way through the industry, but bankruptcy still loomed, and the Detroit companies were desperate for cash.

So it was that Sun Yanchen, the director of legal affairs for Beijing Automotive Industrial Holding Co Ltd, a state-owned enterprise (SOE) that is China's fifth–largest car manufacturer, found himself fighting the Michigan chill. He was there as part of a team sent to negotiahte a deal with one of the Big Three automakers. (Sun says he can't identify which one.) The BAIC officials were hoping to purchase "whole-car technology" from the U.S. company--everything, including designs, patents, and tooling, needed to put together a complete and proven automobile.

After a couple of days spent touring plants and examining equipment, the BAIC team got down to brass tacks. The technology that the U.S. company was offering was for models that had been on the market for almost a decade; in fact, one was about to be discontinued. Executives at the Chinese company had an idea of what they thought would be a fair price.

But so did the executives at the American company.

"It was an extremely high price," recalls Peter Huang, a Beijing partner with Skadden, Arps, Slate, Meagher & Flom who advised and accompanied the BAIC team. The two sides "were so far apart, there really wasn't any point to continue the discussions," Huang adds.

Looking back, Sun laughs about how the negotiation would probably be even shorter today. Speaking through an interpreter, he says: "The fact is that, if we go outside China today and try to buy whole-car technology, no one will sell it to us, no matter what price we are willing to pay."

Sun adds, "There was a small window during the financial crisis because no one could see how long the car industry would be in the trough." Now, he continues, "all U.S. and European automakers recognize that China is going to be the biggest growth market for them in the next decade or so. They would rather not have to compete with us."

BAIC's negotiations with the Detroit automaker were typical--many more of its overseas acquisitions have fallen through than have made it to the finish line. Foreign companies know what the Chinese are after and either demand exorbitant prices, or refuse to sell at all. Other times, there are hidden pitfalls that are only apparent on close inspection. But enough have come together--including one critical deal that Sun helped negotiate with Saab AB in Sweden--that BAIC could soon be one of the first Chinese automakers to step up to the next level.

From Arbitration to Automobiles 

Just six years ago, the global competition among automakers wasn't a concern for Sun, now 38. A law graduate of the prestigious China University of Political Science and Law, he was working at the Beijing Arbitration Commission, where he had steadily risen from clerk to director and full-fledged arbitrator. But in 2005, a friend in government approached him about joining BAIC.

The company did not have a legal department then. But like many SOEs, it was undergoing a process of enterprise reform aimed at transforming it into a more modern, market-oriented business. Sun had little detailed knowledge of China's auto industry at the time, but he knew that it was growing very, very fast. He jumped at the opportunity to be a part of it. When the reform process gave birth to an in-house legal department in 2007, Sun was put in charge. From three people at the start, the department now has a staff of around 60, over half of whom are lawyers.

And grow the industry did. China is now the world's largest auto market, having overtaken the United States in 2009 and extended its lead in 2010. Last year, some 13.8 million cars and light trucks were sold in China, compared to 11.6 million in the U.S. The growth is expected to continue. At an industry conference in January, Sun's boss, BAIC chief executive officer Wang Dazong, confidently predicted that the Chinese market would hit 40 million cars a year within a decade. (Wang is a Cornell Ph.D. and former chief engineer and designer at General Motors Company.)

It is an enormous prize, but for the most part so far, it is non-Chinese companies that are seizing it. Makes by U.S., European, Japanese, and Korean manufacturers account for roughly 70 percent of the passenger cars sold in China. GM, currently the largest foreign automaker in China, said in January that it had sold more cars in China last year than in America, a first for the company. Honda Motor Co., Ltd., likewise found that for the first time, it had sold more cars in China than in Japan in 2010. And China has been Volkswagen AG's biggest market since 2009.

So where are the domestic companies? BAIC and the other Chinese automakers are not really like the car companies that most Westerners are familiar with, though they would like to be. The majority of their production is actually of foreign-branded cars produced through joint venture arrangements with the big names from abroad.

Chinese companies want to sell their own branded cars, however, and many multinational carmakers fear the day that Chinese cars are selling well in their home markets. At this moment, that moment still seems far away. Chinese manufacturers have been largely unable to build cars that can compete with those of the major foreign brands in terms of performance, comfort, reliability, or design. Safety has been a particular hurdle; YouTube features numerous videos of Chinese cars horribly failing crash tests.

But BAIC and the other Chinese companies are now on a global quest to acquire the means to build their own branded cars that can compete. Sun has been in the thick of that effort, dispatched by BAIC to car and auto parts manufacturing hubs around the world. He has been charged with analyzing the risks and negotiating the terms of acquisitions and investments that could potentially yield prized automotive technology. It has been a tricky balancing act, requiring him to keep one foot in the bureaucratic world of SOEs and one in the fast-paced arena of cross-border deals.

Sun's substantial role in the dealmaking process is unusual for an in-house lawyer, and perhaps doubly so for one at a Chinese SOE. One reason that he's been given added responsibility is that negotiations often center on IP rights and other legal issues. Plus, Sun is also part of a relatively small management team that numbers around 50 from Wang on down. By comparison, an SOE like China Petroleum and Chemical Corporation (Sinopec) has several thousand management-level staffers.

The Limits of Learning on the Job

BAIC is wholly owned by the municipal government of the city of Beijing. It currently has a workforce of around 50,000 employees, average annual revenue of roughly $6.2 billion, and sales of 1.5 million cars last year.

Founded in 1958, BAIC was long a maker of jeep-like vehicles used by the Chinese military. Appropriately, it began building Jeep Cherokee sport utility vehicles in 1984 under China's first joint venture with a foreign automaker--American Motors Corp. The JV then went to Chrysler Corporation, which took over AMC in 1987, and then to Daimler AG, which acquired Chrysler in 1998. Daimler still has the JV with BAIC, even though it sold Chrysler in 2007. With Daimler, BAIC produces Mercedes-Benz E- and C-Class sedans. BAIC's other big JV partner is Hyundai Motor Company, with which it produces Elantra sedans.

Shanghai Automotive Industry Corp. is China's biggest domestic car company, and it accordingly has JVs with the biggest foreign names in China, GM and Volkswagen AG. The next-largest domestic automaker, Dongfeng Motor Corporation, has partnered with Honda, Nissan Motors Corporation, Kia Motors Corporation, and Peugeot Motor Corporation. Still other JVs produce Audis, BMWs, Fiats, Fords, Mazdas, Mitsubishis, and Toyotas.

Like Japan and South Korea before it, China has long viewed the development of a strong domestic auto industry as a benchmark of advanced industrial status. When the Chinese government first invited foreign automakers to enter into JVs in the late 1970s, it figured it was trading market access for technology. By building cars under license with foreign manufacturers, Chinese companies hoped to gain the technology and know-how to compete on their own. But it hasn't worked out that way.

While the Chinese partners have shared in the JV profits, the technology to build the cars remains firmly in their foreign partners' hands. The JV licenses under which cars are produced are heavily restricted, reserving all intellectual property rights to the foreign companies. In addition, supply chains for certain critical parts are often strictly controlled. The whole system is set up so that the last car BAIC would be able to produce on its own is a copycat version of the Mercedes sedans that it builds under license from Daimler.

As if that weren't enough, most Chinese JVs can only manufacture older production models that are several years behind the ones the foreign companies produce in their home markets. (In perhaps the most visible case, Volkswagen still produces and sells the boxy Santana sedan in China, a model that VW introduced in the West in 1981 and discontinued in 1988.) Wealthy Chinese who want the latest foreign models directly import their cars, paying heavy duties to do so. Last year China imported 800,000 cars, almost double the number from 2009.

But even without acquiring the IP rights to foreign cars, haven't the Chinese companies learned how to make cars just by doing it for the last two or three decades?

"There is a limit to how much you can learn just by watching," says Sun. "Typically, a German car model takes seven years to develop. It has to go through 100,000 miles of testing before it's certified. Just knowing how they make it doesn't mean you can do it, with all the R&D they put into it."

Chinese companies are pouring money into developing their own R&D, but the fastest way to market is to acquire someone else's technology. This is not just a matter of getting better brakes or a more advanced powertrain, though. Individual parts can often be acquired relatively easily, but it is the whole-car technology that Chinese manufacturers have generally lacked.

"If you have your own branded car, you need to know every bit of that car," explains Skadden's Huang. "You can source many parts from the OEMs [original equipment manufacturers], but you need to know how they are going to fit together."

The SOE Mentality 

The 2008 financial meltdown seemed to create the perfect environment for BAIC to acquire its long-desired whole-car technology. A number of established automakers were looking into the abyss and desperate to sell themselves or their assets. In this frenzied environment, GM almost sold its Hummer brand to the obscure Sichuan Tengzhong Heavy Industrial Machinery Co., Ltd. (The deal ultimately collapsed, and GM shut the line down.) Geely Automobile Holdings Ltd., one of China's largest privately held carmakers, last spring acquired Sweden's fabled AB Volvo from Ford for $1.8 billion.

But it's no simple matter for a bureaucratic Chinese SOE to seize such opportunities. "SOEs have a distinct management methodology and a thinking process of how to make decisions that is totally different from in the private enterprise," says Sun. "You have to follow the state-owned enterprise mentality to make decisions."

In China, the biggest names in almost every sector are SOEs. Bank of China, Industrial and Commercial Bank of China Limited (ICBC), PetroChina Company Limited, China Mobile Limited, and Aluminum Corporation of China Limited (Chinalco) are a few of the better-known ones. SOEs have evolved with the rest of China's economy. Many are now publicly traded in Shanghai, Hong Kong, or even New York, and most have mainly professional as opposed to political management. BAIC's Wang is a bit unusual in having long experience overseas with GM; most of the other heads of automotive SOEs have somewhat more bureaucratic backgrounds.

But they still stand apart. A whole host of special rules and regulations, governed by the State-owned Assets Supervision and Administration Commission (SASAC), apply only to SOEs. As chief in-house lawyer for an SOE, Sun must know those rules well, along with all the more general rules that apply to all companies. Though BAIC is owned by a city government and not the central government (like PetroChina or Chinalco), it is still subject to the same rules.

For instance, a sale of SOE assets cannot simply be negotiated; it must go through proper channels, including valuation analyses to determine a price threshold. Conversely, overseas acquisitions must follow a prescribed set of procedures for various approvals by SASAC, the Ministry of Commerce (MOFCOM), the National Development and Reform Commission (NDRC), and the State Administration of Foreign Exchange (SAFE).

When it comes to technology, SOEs must also demonstrate that they will not be importing to China anything that's inferior or obsolete, and they must present a plan for implementation of new technology into existing platforms. The NDRC also acts as a referee among Chinese companies who might all be eyeing the same technological asset.

"They will definitely step in and decide whose turn it is," notes Sun.

The regulatory burdens on Chinese SOEs complicates their negotiations with foreign companies, especially those in distress, who are typically in a hurry to get deals done. "It can increase the uncertainty of the deal and put Chinese bidders at a disadvantage," says Huang.

Calculating Risk

Of course, timing is only one risk to a successful deal. Sun is quite familiar with other challenges, as roughly 70 percent of BAIC deals have failed to close.

The company's planning department, which first moots potential deals brought in by investment bankers or industry contacts, tends to bring Sun in early on to figure out how to structure the transactions and identify their transaction risks. "The number one concern at the beginning is to identify who are the counterparties, what kind of company they are," he says. "Then it's the ownership of the assets, whether the title is clean or not."

When dealing with technology acquisitions, there is also the issue of whether the deals will pass muster with bodies like the Committee on Foreign Investment in the United States (CFIUS), which can recommend that the president block deals deemed detrimental to U.S. national security.

"If the technology involved potentially has some military uses, then the difficulty of getting an export license is a very big concern," says Sun.

The challenge is weighing those risks against the goals of the proposed deal. Sun finds his background as an arbitrator is helpful in that regard. "An arbitrator's job is all about dispute resolution, including settling risk," he says. "Business negotiation is about identifying risks and then working to settle differences between the parties."

The main reason that negotiations fail is that the parties can't agree on the price. In many cases, the foreign company simply wants too much. But it's not always so clear, as conditions and terms embedded in a deal can vastly increase its cost beyond the nominal price.

Sun recalls a negotiation with a U.S. auto parts company that one of BAIC's subsidiaries was thinking about buying. "The price was essentially $1 because that company was about to go into bankruptcy," he recalls. "But when we went to look at the lender's terms for the restructuring, it became very, very expensive. We had to agree to repay 45 percent of the existing debt and roll over the rest, making it a billion-dollar acquisition."

Going for the Prize

Sometimes a risky deal can pay off. As the economy plummeted in 2008 and GM looked at assets to cast off, Saab, the quirky Swedish car line it acquired in 1990, was near the top of the list. Though well regarded from an engineering standpoint, the brand's sales had waned since the 1990s, and GM wanted out.

Saab had what BAIC wanted, though. "The main attractiveness of Saab was that it has whole-car technology," Sun recalls.

But BAIC was late to the table. It had been chasing Opel, GM's much-larger German division. BAIC was dropped from the Opel competition in late July 2009 over what it said were "intellectual property disagreements." Presumably, GM did not want to have to compete against its own technology in China, its new top market. Ultimately, GM decided not to sell Opel to anyone.

By the time BAIC became interested in Saab, another company had already agreed to buy the line. In June 2009 a consortium led by Koenigsegg Automotive AB, a tiny Swedish maker of so-called supercars, had outbid two other potential buyers for Saab. With Swedish government backing, Koenigsegg had lined up $600 million in financing from the European Investment Bank to support its bid. But it was open to other partners with money.

Getting involved with Koenigsegg's complicated deal would have spooked even the most seasoned deal lawyer. In the end, the prize was deemed worth it, and BAIC decided to become a minority shareholder in the new Saab.

"It was a highly structured transaction, and the goals of the parties were very far apart," recalls Mark Uhrynuk, a partner in Mayer Brown's Hong Kong office who represented BAIC in the deal. "We also had a very short amount of time."

Skadden, with which BAIC had worked before in China, was representing Koenigsegg this time, and the documents were flying fast and furious.

"There was at least a full week in Sweden with literally two or three hours of sleep a night," says Uhrynuk.

The Mayer Brown partner praises Sun for keeping things together during the intense negotiations. "What impressed me was that he was very organized and very careful at keeping things on track with the deal," says Uhrynuk. "He reviewed all the drafts and gave comments. Meanwhile, there were clearly a lot of things internally that needed to happen to make sure things could go forward."

Koenigsegg and BAIC announced a memorandum of understanding on September 9, 2009. The envisioned deal saw Koenigsegg becoming the 100 percent owner of Saab, and BAIC as a minority shareholder in Koenigsegg. Terms were not disclosed, but the two companies did agree to "explore growth opportunities in the Chinese and international markets for the products of Saab Automobile and BAIC.

On November 24, less than two months later, the whole thing fell apart. Koenigsegg abruptly pulled out of its deal to buy Saab amid suspicion that financing for the acquisition was collapsing. The Swedish government ruled out a bailout for Saab, and GM began talking about shutting things down.

"There was a break," recalls Uhrynuk. "There were the usual busted-deal feelings. It wasn't obvious one way or the other what would happen next."

But Koenigsegg's departure greatly simplified things for BAIC. It no longer had to deal with being a consortium member and a minority partner. It could go after exactly what it wanted.

In a matter of weeks, BAIC was back at the table. In December a deal was announced whereby, for a relatively modest $200 million, BAIC would take ownership of the IP rights and production tooling for the then-current model Saab 9-5 sedan and an older model of the Saab 9-3 sedan--whole-car technology. (Saab would eventually be acquired by another specialty sportscar maker, the Netherlands's Spyker Cars N.V., in February 2010.)

The 9-3 and 9-5 technology is going to be the backbone of a new line of BAIC–brand sedans, the first models of which--the C60 and C71--could hit the market sometime this year. Seeing how quickly and how strongly struggling foreign automakers like GM have turned things around since 2009, Sun is glad that BAIC got what it needed from Saab during that short window of opportunity.

The acquisition puts BAIC in a good position compared to its domestic competitors. The Saab technology is somewhat newer than what rival SAIC acquired from defunct British car company MG Rover Group Limited in 2005. Other Chinese auto companies have mainly based models on expensive licensed technology from companies like Mazda or Audi.

Though Geely made a bigger splash when it bought Volvo outright, it faces far greater perils. For one thing, it must run a foreign company, which will remain based in Sweden and have its own management. Previous attempts by Chinese companies to run foreign businesses have not been regarded as huge successes; SAIC took over Korea's fourth-largest car company, Ssangyong Motor Company, in 2004, leaving it in receivership in 2009. Moreover, certain Volvo technologies remain owned by Ford, which licenses them to Geely.

And all is not over on the acquisition front for BAIC. "Even if you have the whole-car technology, different parts may be outdated," Sun notes. "You may be seeking new chassis technology or a new powertrain. Chinese companies are still looking for improvement of certain parts."

BAIC spent much of 2010 looking for ways to capitalize on its Saab designs. Indeed, BAIC went back to Sweden earlier this year and paid around $43 million for the factory and technology rights of transmission maker Weigl KG. The company is also reportedly interested in acquiring legendary Italian auto design house Pininfarina S.p.A., best known for its work with Ferrari. To boost production, BAIC also bought a smaller domestic carmaker, mostly to acquire its plants in southern China.

And there's no reason that BAIC will stop at two sedan models. "Every Chinese automaker is trying to develop a full line," says Sun. "If there is an opportunity to fill a gap, I think we would like to take it."

Email: alin@alm.com