November 2023
Lihui Jiang and Teresa Huang
According to statistics from the National Bureau of Statistics, China recorded a 5.2%[1] GDP growth rate in the first three quarters of 2023. Yet, given the unpredictable economic landscape, both globally and domestically, numerous enterprises are recalibrating their strategic frameworks within Mainland China, resulting in a noticeable increase in merger and acquisition (“M&A”) activities. Furthermore, as legislative and regulatory systems continue to evolve and intensify, M&A transactions have grown increasingly intricate and demanding. Thus, what exactly does the M&A process entail in China, and what key considerations should companies, particularly those with foreign investments, bear in mind during this process?
The principal targets for mergers and acquisitions in the current market are equity and assets. While equity acquisition continues to dominate, instances of asset acquisition also arise. Although these two transaction models vary slightly, each carrying its own set of advantages and drawbacks, the overall acquisition process follows a similar trajectory. It encompasses preliminary preparation and agreements, due diligence, negotiation leading to final agreements, and closing.
I. Preparation Stage and Preliminary Agreement
During the preparatory phase of an M&A deal, both parties engage in initial contacts and negotiations. The investor’s primary tasks involve devising the M&A plan, assembling a professional team, initiating contact with the target company, and executing a preliminary agreement with the seller. This preliminary agreement, often termed a “Letter of Intent”(“LOI”) and occasionally referred to as a “Memorandum of Understanding” or “Term Sheet”, etc. It stands as a pivotal document where both parties express their initial intent to collaborate and it serves as the groundwork for the subsequent due diligence process.
According to business practices, a LOI typically lacks exhaustive content, and except for specific clauses, it is not intended to be legally binding on the two parties. Therefore, LOI often lacks substantial legal weight and its significance varies among companies. Nevertheless, its essence lies in confirming the preliminary understanding established through iterative communication, discussion, and negotiation in the initial phases, setting the stage for subsequent negotiations. If one party signs a LOI with reservations about its binding nature to facilitate the deal but later intends to modify or remove specific clauses in the final agreement, this action may relinquish some negotiating leverage and potentially empower the other party during negotiations.
Typically, a LOI comprises binding clauses such as confidentiality, exclusivity, non-solicitation, and dispute resolution. Confidentiality and exclusivity, at times, might exist as separate agreements. Confidentiality clauses aim to ensure that information disclosed during due diligence or negotiations serves the agreed purpose only and remains confidential. It is important to note that Chinese law doesn’t inherently protect information deemed public. Exclusivity clauses usually prevent the seller from seeking simultaneous deals with third parties for a specified period. Depending on the transaction context, these clauses may bind both parties.
Moreover, the non-binding aspect of a LOI is not absolute. In M&A transactions, scenarios arise where despite signing a LOI, the deal fails to materialize due to various reasons, leading to disputes. Courts, in specific instances, may ascertain the nature of the LOI based on its specifics, recognizing it as a negotiable document[2] or a pre-contractual agreement[3]. Consequently, both parties must determine their corresponding liabilities based on the identified nature. To summarize, companies should handle the terms of the LOI cautiously to mitigate diverse risks during this stage.
II. Due Diligence
Due diligence, a fundamental step in the M&A transaction process, encompasses various investigations conducted to assess risks of the transaction. It involves legal due diligence conducted by lawyers, financial due diligence carried out by accountants, and tax assessments. Depending on the characteristics of individual industry, additional due diligence types might be performed, including business, environmental, and technical evaluations on patents and trade secrets. This section primarily delves into the specifics of legal due diligence.
Legal due diligence, also referred to as prudent investigation, occurs typically after both parties express preliminary cooperation intent. The buyer conducts a comprehensive examination and evaluation of various facets of the target company, covering its organizational and shareholder structure, major assets, credits and debts, significant contracts, intellectual property rights, financial audits, labor relations, environmental compliance, and legal disputes. The findings from due diligence offer investors insights into existing or potential risks associated with the target company. This information serves as a basis for internal discussions among the investor’s professional team to devise appropriate strategies. Moreover, it assists investors in making informed decisions regarding the feasibility of the transaction, its structure, pricing, and other crucial considerations. This proactive approach minimizes the risk of making inappropriate investment judgments or decisions due to asymmetrical information.
While the risks revealed during due diligence vary among companies, certain issues remain common. One prevalent concern is the complexity or deficiencies in the original shareholding structure of the target company. For instance, in private companies, shares might be scattered among different family members, or some shareholders may have their shares held by proxies. These complexities significantly increase transaction risks. Moreover, labor relation matters often pose typical challenges. Instances where companies inadequately contribute to employee social security are common. In such scenarios, investors must weigh options, whether to retain employees with associated historical risks, terminate labor relations, or explore alternative resolutions. Additionally, the retention of key employees holding incentive shares within the company is a critical consideration for investors.
Sometimes, due diligence exposes numerous issues within the target company. In addition to those mentioned above, there may also be substantial external debt, material contract breaches, incomplete intellectual property rights or potential licensing disputes, flaws in land use rights, and significant pending litigation, etc. In such scenarios, the buyer might contemplate forgoing the purchase of equity and instead opt for acquiring the target company’s assets. This shift prompts considerations regarding asset transfer taxes and the simultaneous transfer feasibility of licenses pertaining to specific business activities.
III. Negotiation and M&A Agreements
To streamline the overall transaction process, the parties usually initiate negotiations and discussions on pertinent transactional agreements concurrently with the due diligence phase, including but not limited to equity or asset transfer agreement, shareholder arrangement, and collaborative business agreements. Subsequently, after the due diligence findings emerge, both parties reconvene for further talks and execute the final agreements.
Typically led by the company’s business team, negotiations focus on commercial aspects. Certain non-criminal economic risks disclosed during due diligence, such as potential compensations, fines, temporary operational suspensions, or the need to reapply for licenses, are transformed into transactional costs or integrated into the agreement as prerequisites, declarations, or warranties. At this juncture, careful communication and the signing of pertinent transactional agreements are pivotal. Legal advisors representing the investor emphasize warranty and indemnity clauses while drafting these agreements. Their focus is on encompassing disclosed or potential risks and devising appropriate remedies to safeguard the investor’s interests.
Concerning the dispute resolution clause for foreign investors, Chinese laws do not restrict the M&A agreements involving foreign-related aspects from being governed by foreign law. Depending on circumstances—such as whether the target company is a domestic or a foreign-controlled entity—investors can opt for the applicable law of their choice. However, issues related to Sino-foreign joint venture contracts performed within the territory of the People’s Republic of China mandate the compulsory application of Chinese law[4]. Moreover, arbitration, favored for its efficiency and confidentiality, is often the chosen dispute resolution mechanism. Arbitration institutions in Hong Kong or Singapore are popular choices for foreign-related M&A transactions.
IV. Closing
Unlike the conventional “cash on delivery” model used for goods, closing of equity transaction involves a multi-step process encompassing agreement signings, payments, transfer of seals, key licenses, and documentation, as well as filing and registration. Payment terms often spark significant negotiation between parties. While some transactions entail full payment upon closing, a prevalent trend is toward staggered payments or an initial down payment at the closing, with contingent conditions for the final payment. Investors tailor payment conditions based on their specific priorities. For instance, if they prioritize the target company’s operational prowess, they might stipulate conditions such as achieving a specific turnover in the acquisition year for the final payment.
In Chinese legal practice, the effectiveness of a share transfer agreement and the actual transfer of shares are typically assessed separately. When the equity transfer agreement takes effect, the investor acquires a debt claim but doesn’t automatically assume ownership of the shares[5]. To secure ownership rights, investors must complete relevant registrations. As per Article 8 of the “Minutes of the National Court Civil and Commercial Trial Work Conference” of the Supreme People’s Court, if an investor asserts ownership based on their name being recorded in the shareholder registry, the court will support this claim in accordance with the law. Furthermore, Article 32 of the Company Law mandates companies to register their shareholders’ names with the competent company registration authority, usually the Market Supervision Administration (“MSA”). Failing to register or update such records cannot be enforced against third parties. In cases involving asset acquisitions, the transfer of certain movable and immovable property is legally recognized through appropriate registrations as the transfer of ownership. For foreign investors, the registration process for share transfers might seem unfamiliar and more passive. Often, they prefer making completion of registration with the MSA a condition for final payment.
Another crucial aspect in Mainland China revolves around the validation of certain documents and contracts based on the presence of the appropriate seals. Companies might possess multiple seals designated for various purposes, such as the official seal, financial seal, contract seal, invoice seal, and legal representative seal. Among these, the “official seal” represents the corporate authority of the company and holds the highest legal significance. Additionally, the financial seal carries significant importance. Failing to acquire the necessary seals of the target company can pose challenges in obtaining effective control of the target company.
Conclusion
Lastly, here are some emerging trends in mergers and acquisitions. Seller-initiated due diligence, where sellers initiate due diligence on their own company, is gaining ground in Europe and the United States[6]. This approach not only allows sellers to proactively understand their company’s disclosed risks or potential value, providing them negotiation leverage, but also saves time and facilitates negotiations with a wider range of potential buyers. Additionally, foreign investors are diversifying their selection of law firms. Some prioritize foreign firms for easier communication due to language and cultural similarities, while others value local firms for their profound understanding of local issues and circumstances.
Given the complexity of legal matters and associated risks in the M&A process, whether as the buyer or seller, seeking early assistance from legal professionals is crucial for the seamless completion of the M&A process.
[1] National Bureau of Statistics: http://www.stats.gov.cn/sj/sjjd/202310/t20231018_1943691.html
[2] Cases of the Supreme People’s Court: No.263[2014] Petition Civil Division
[3] Cases of the Supreme People’s Court: No.366 [2015] of the trial of final instance by the Second Civil Division
[4] Article 467 of the Civil Code of the People’s Republic of China
[5] Guangzhou Arbitration Commission; https://www.gzac.org/llyj/1620
[6] https://www.corporatefinanceineurope.eu/due-diligence/vendor-due-diligence/
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