China question: How do I flush out informal and oral agreements, hidden shareholders and undisclosed liabilities, and give myself more comfort and protection?
March 28, 2012 | BY
clpstaff &clp articles &During mergers and acquisitions, the target company provides some short and simple Chinese contracts, but I understand there are informal arrangements behind the papers. How do I flush out informal and oral agreements, hidden shareholders and undisclosed liabilities, and give myself more comfort and protection?
The international perspective
For many multinationals, China represents the market with the best investment potential for M&A according to a joint survey by Hogan Lovells and Financial Times in 2011. The same survey also found China is the most difficult region for deal making. One reason is that traditional M&A due diligence has its limits in China. Multinational corporations are used to more developed markets in which most of the company's business and financial information are well documented and accessible as long as the seller is willing to cooperate. This is usually not the case in China. Foreign acquirers frequently find their Chinese targets are unable to provide accurate or complete information within an expected timeframe. This is because the company does not maintain a good documentation system, or key information is simply not put in writing for cultural and other reasons.
One typical example is contracts. In many developed markets, commercial contracts define the company's relationship with its customers, suppliers, employees, shareholders and other stake holders. By Western standards, Chinese contracts are often skinny and viewed as unsophisticated. They run only a few pages, setting out the most basic operating terms, even for business transactions of a significant value. Many of the key business relationships are not defined by contract, but to a large extent by guanxi（关系）or personal relationships. For instance, a change of control clause is rarely included in most Chinese contracts (other than bank loan agreements). However, buyers must keep asking questions about whether the departure of the seller would disrupt the company's relationship with its business partners and local governments. In some cases, it is advisable to visit key customers or suppliers, seeking their consent as a closing condition regardless of whether this is required under the existing contracts.
So how do you find out the full picture of the business that you are buying? Clearly, you should not simply rely on the seller's written responses to a Western style due diligence questionnaire, many of which come back with: “We do not have such documents” written on them. You or your advisors need to sit down with the seller and walk them through each item, explaining what you are looking for and why it is important. You will discover many of the items on your questionnaire do not lead to any concrete documents. Then you are directed to speak to senior management for key queries. As such, management interviews can serve as an important tool to access the unwritten, sometimes rather basic information, such as who are the real shareholders (some are reluctant to register their names for political reasons; others simply trust their partners). Management interviews may also reveal that, in connection with its business dealings, the company does not always follow what is written in the contracts or corporate documents. Smart buyers would ask to talk to the target's managers at all levels, sometimes with the same set of questions, trying to piece together a consistent story. It is also useful to compare notes between the legal and financial advisors and fill in the gaps or work out the inconsistencies.
If you carry out due diligence properly, you are likely to get 70% to 80% of the target company's data. Your sale and purchase agreement (SPA) could address some of the gap through representations, warranties and indemnities. But more importantly, you need to create a structure to cover the remaining risks. For instance, persuade the seller to stay as a minority shareholder after closing, or retain existing management and give them stock options so they can share in your success. Every business has a human side. In China, it is even more important that you identify the individuals who have access to the key resources of the business and properly incentivise them. In my view, carrot tends to work better than stick in the context of China M&A, as we still have the issue of enforcement in China.
Xu Liang
Hogan Lovells, Beijing
The domestic perspective
During M&A, conducting due diligence on Chinese target companies is not only essential but also important to acquirers. Whether a Chinese or foreign enterprise, conducting comprehensive due diligence increases the chance of successful integration and mitigation of risks in the business or the assets of the target companies to be acquired. During due diligence, it is common to find that Chinese targets entered into short and simple contracts with informal or side arrangements. Such contracts expose the target company to serious contractual liabilities or drag them into troublesome contractual disputes. This is because of over-simple or loosely drafted provisions, which would likely expose the target (and eventually the acquirer) to costly and time-consuming legal proceedings.
An acquirer can consider the following measures during due diligence to eliminate, or at least mitigate the legal risks associated with short and simple contracts. Interviews with management personnel, who were in charge of the transactions under the contracts, can identify such arrangements. This allows for the assessment of associated risks and liabilities, the impact of the proposed transaction, and mitigation measures or solutions.
However, the information made available through these interviews may be insufficient or limited. In our experience, interviews with lower-level business personnel are usually more helpful because they may be more open to discussing the situation and confirm how the contracts were concluded and performed. An acquirer can sometimes decipher informal arrangements through online searches. Reviewing supplementary documents such as financial credentials and the audit report may also help identify the risks associated with short and simple contracts.
After identifying informal arrangements, the acquirer can then assess whether such arrangements are acceptable from both a legal and a business perspective. If the informal arrangements do not constitute legally binding obligations upon the parties, enforceable under applicable law or otherwise not acceptable from a business perspective, the acquirer can insist on having a covenant clause under the transaction agreement. The covenant clause imposes an obligation on the target company to conduct business according to law and not maintain informal arrangements with counterparties. This is coupled with an indemnification clause against the seller, should the target company fail to comply.
Alternatively, the acquirer may consider asking the seller to amend the target company's short and simple contracts. They can specify in the transaction agreements that certain contracts have to be amended as a pre-closing condition. If this pre-closing condition is not met, then the acquirer has the option of not closing the deal. It can also be in the form of a post-closing condition (if such post-closing condition is not met, the seller must indemnify the acquirer).
Despite great efforts, there is the potential that informal or side agreements may not be fully identified. In this situation, customary provisions in the transaction agreement, such as representation and warranties and indemnification clauses provide important protection. For example, the representation and warranties clause should specify that contracts, as set out in the disclosure schedule prepared by the seller, encompass all the material contracts the target company is party to and has remaining actual or contingent liability. The clause should also ensure the seller provides true and complete copies of all such contracts. An indemnification provision should specify that the seller should indemnify the acquirer for any losses, claims, costs, expenses and penalties arising or resulting from the breach of such representation or warranty made by the seller.
Zhang Wei
Jun He Law Offices, Beijing
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