Experience from the Anti-Monopoly Law Decision in China – Part II

[Editor’s note:  This post continues yesterday’s article, found here.]

3.2. Methodology and Assumptions

This “legal discount” test provides how much Coca Cola may lose in the acquisition of Huiyuan Juice if the application were rejected because of improper enforcement of law.

The potential loss Coca Cola suffered was the potential net income of the Huiyuan Juice for fiscal year 2009, the first year of operation if the transaction were approved.

It was difficult to predict whether the profit of the new company would increase because it was a component of the Coca Cola (by economies of scale, for example) or decrease (as actually occurred with Huiyuan in year 2010). We assumed that the annual profit of the new company was stable.

It was not sufficient that we merely estimated the profit if Coca Cola successfully purchased Huiyuan, because Coca Cola’s funding does not exist in a vacuum, i.e., Coca Cola would not be required to pay for the costs of funding, whether dividends to shareholders or interest expense to creditors, if it did not spend the USD24 billion for the deal.

Thus, potential income should be divided by the weighted average cost of capital (WACC) of Coca Cola.

Because legal risk is variable case by case, the analysis only examines the highest level of loss caused by uncertainty in the rule of law in the Chinese legal environment. This assumption also matches the conservatism in accounting principle, which suggests that expenses should be over-estimated at their highest possibility when the amount is not certain.

To reflect the possibility of judicial intervention, the discount should be multiplied by 1/67, which reflects the highest legal risk.

The potential return on the project resulting from the assumptions made above is that made for USD24 billion in investment funds.

3.3. Legal Risks Discount without the Rule of Law 

[Editor’s note:  This section has been omitted.  For in-depth calculations, please contact the author.]

3.4. Limitations

In short, the analysis above shows that Coca Cola lost a chance to enter into a project with a potential return on investment of 40.12%, and all investors in the market would suffer a loss of up to 0.60% of their investment in the form of lost profit if the Chinese judiciary did not reasonably enforce the law.

This analysis does not conclude figures about the amount of legal risk investors in China market generally face but only provides a method for decision makers to estimate the potential costs caused by legal risk.

This figure is variable for any individual investment project. Coca Cola’s case is only applicable when the investment amount, the profit of the subject matter and the number of decisions are all the same (and available). It also only reflects the circumstance of merger and acquisition in the competition environment of a certain era and industry.

The method is limited by general statistical limitations, such as small sampling. In this case, the possibility of rejection, 1/67, was based on the number of decisions by the MOFCOM in 2009. With this small sampling, the result may significantly change if the MOFCOM had disapproved of one more application.

Simultaneously, it may not be easy to obtain figures for Chinese judiciary decisions, which does not typically release such information—the 2009 figures for the merger and acquisition application is a response from the spokesperson to the mass media questioning the rationale of the Coca Cola case.

However, this does not harm the value of the “legal risk discount” test, although it sometimes may be impossible to obtain accurate results because the method is a direction about how investors should approach risk in each case.

After his talk titled “Has Economic Analysis Improved (Regulatory) Law Making?” held in University of Vienna (16 May 2011), Robert Hahn agreed that conclusions might be adjusted when new information is available when I asked him whether updated information might lead to different results in his 2001 article. It is not a default of the logic that Hahn suggested in his articles, but simply a result of new information because cellphone used in 2001 was not as common as in 2010.

As for the legal risk discount, investors may perfect the result by inputting figures when shareholders know much than general public about their industry and their figures.

4. Implications

These results might cause the false impression that 0.60% of total investment is insignificant, but this is not the case.

The 0.60% legal discount risk at the state level represents the risk level of the merger and acquisition environment in the entire Chinese market; this risk is shared by all market participants. Nonetheless, Coca Cola, the only party who is disapproved, assumed all the profit loss.

At the company level, Coca Cola’s loss of potential profit, 40.12%, is nearly double the company’s net profit rate in 2009, which was 22.28%. The MOFCOM’s argument, that 1/67 is a low possibility of rejection, is not reasonable when it is not affordable for a company that is disapproved.

At the state level, a 0.60% risk may cause a huge consequence because foreign direct investment in China is more than a hundred billion US Dollars.

The problem may not appear as serious as it is because the Chinese market remains attractive. However, a minor risk discount would become material if the profit margin drops, and the growth of the Chinese economy is in decline. Any risks that might be negligible during economic flourishing would be unaffordable—and this might occur if the reality is that investors are not confident in the rule of law in China.

It may be arbitrary to conclude that foreign direct investment in China has decreased in the past because of legal risk, but it is clear that any uncertainty that may negatively affect investment will make be worse if economic growth weakens.

The “Legal Risk Discount” analysis offers a tool for investors to design financial plans and provides a reason for the Chinese government to improve its legal environment. As emphasized above, there is no strong evidence to show that the MOFCOM rejected Coca Cola’s application for political reasons. If the Chinese judiciary has sufficient ground to support its decisions, however, it should not merely provide a 777 Chinese word announcement with no detailed explanation; instead, it should provide sufficient information to let the general public understand its rationale.