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The Legal and Commercial Issues in terms of Cross-Border M&A Transactions in PRC

August 2019 - Corporate & Commercial. Legal Developments by V&T Law Firm.

More articles by this firm.

  Author: Su Yuqiang  Partner 

1. The Legal Due Diligence Conducted by Acquirer 

In a cross-border M&A transaction, the legal due diligence conducted by experienced attorneys for Acquirer towards Target Company is essential. It is a way for Acquirer to take a full look of Target Company and detect minor defects or risks beneath the surface of Target Company. To conduct legal due diligence requires the capabilities to sense the legal and commercial defects or risks of Target Company from attorneys. 

Therefore, there are several essential aspects in the due diligence worth the attention:

(1) The business scope of Target Company

On the top of the whole due diligence, the investigation of business scope of Target Company is the first priority. The reason to do so is that certain business scope might require permission or qualification issued by Competent Authorities under PRC laws and regulations. In the event that the business scope of Target Company falls into the business scope that requires permission or qualification from Competent Authorities, in the due diligence, attorneys should verify whether Target Company has obtained such permission or qualification issued by Competent Authorities. Furthermore, if Target Company is a Foreign Invested Entity (“FIE”), attorneys should pay more attention to whether business scope of Target Company matches any business in Special Administrative Measures (Negative List) for Foreign Investment Access (2019 Edition (“Negative List 2019”). If the business scope of Target Company falls in Negative List 2019, the certain business scope requires the controlling party of the business would be a local Chinese corporate or such certain business would be prohibited from FIE.

 (2)     The debts or liabilities lie in the Selling Equity

There are two forms of transactions through M&A, the transfer of assets and transfer of equity. What we discuss here is transfer of equity through M&A, for it is the most popular way to settle the deal. Though the transfer of assets is safer and clean, it is also more complicated, especially when it relates to real estates, therefore, most of M&A transactions are done by the transfer of equity. However, compared with the transfer of assets, transfer of equity may cause problems. The key problem of transfer of equity would be the debts or liabilities in the equity, especially the potential debts or liabilities. Therefore, the legal due diligence conducted by experienced attorneys would be highly necessary for finding out those debts or liabilities lie in the transferring equity.

(3) Potential and existing lawsuits or arbitrations against Target Company

The lawsuits which have been issued verdicts from courts could be verified via China Judgment Online website if Target Company is a PRC legal entity. However, it is difficult to verify potential or ongoing lawsuits and arbitrations of Target Company for attorneys. The potential or ongoing lawsuits and arbitrations rely on the self-disclosure of Target Company and Selling Party, but in order to avoid any potential or ongoing lawsuits and arbitrations that might bring loss to Target Company, we could arrange warrants or representations from selling party in SPA in terms of selling party’s false disclosure of any lawsuits and arbitrations which bring loss to Target Company and eventually harm the Acquirer, all such loss shall be borne by the Selling Party.

Sure, there will be other issues should be viewed in due diligence phrase. Above mentioned three issues are the ones we believe important and essential for Acquirer’s attention.

2.   The Share Purchase Agreement (“SPA”)

(1) The Parties to enter into the SPA

In a cross-border M&A transaction, at least one of the Parties to enter into the SPA is a foreign legal entity. Our team used to help a client to close a typical cross-border acquisition of equity of a PRC Target Company owned by a Germany company (“Seller”).

In this transaction, Seller is going to sell its 100% equity of Target Company in PRC. Our client is a Hong Kong company and prepared to acquire 100% equity of Target Company from Seller.

(2) The transaction schemes

The transaction scheme is the core of a M&A transaction. It relates to the safety of the whole deal. In the foresaid transaction, we hear the needs of our client and help them design the following scheme:

1)    The sole shareholder of Target Company is a Germany corporate, who holds 100% equity intertest of Target Company.

2)    The Germany corporate has an affiliate company that lends several loans to Target Company.

On the top of that, if our client pays 100% of the Equity Transfer Price, and eventually owns 100% equity interest of Target Company after the Completion of transaction, our client may face tremendous debts hold by affiliate company of the Seller. We have to figure out a way to help our client resolve the debts issues. The 100% Equity Transfer Price is a reflection of net assets plus future valuation of Target Company, which is the combination of assets and debts of Target Company, therefore, after the payment of equity transfer price, the assets should be owned by our client via equity transfer and the debts should be resolved. However, if we just ask the affiliate company of Seller to waive all the debts after the Completion of transaction, our client may face tax issues due to debts waiver (the waiver of debts raises profits in the book, which leads to income taxes).

We suggest our client to conclude a deal with affiliate company of Seller to accept the transfer of debts. There are two reasons for us to suggest our client to accept the transfer of debts instead of waiver of debts: i. taxes avoidance; ii. safety of transaction. In accordance with the Administrative Measures on Registration of Foreign Debt (“Foreign Debt Registration”), all the debts owned by a FIE to a PRC corporate should be registered in the State Administration of Foreign Exchange (“SAFE”) regarding of the establishment, adjustment and cancellation of debts.

The waiver of debts would be registered as cancellation of debts in SAFE, which might cause suspicions from SAFE due to money laundry and raise tons of questions from authorities. For the sake of safety of this transaction and registration in SAFE, we believe the transfer of debts would be the best choice of our client. Therefore, we introduce to our client the payment scheme: 60% of total equity transfer price would be defined in SPA for equity transfer; 40% of total equity transfer price would be defined in Loan Transfer Agreement (“LTA”) for transfer of all debts. The fundamental transaction scheme is as following: 12

We believe the transaction scheme is the most important issue regarding of M&A transaction. Seeing from foresaid case, there would be three important keys we have to take into account before introducing the transaction scheme: i. tax issues; ii. safety of the transaction; iii. efficiency and effectiveness of the transaction and all these three keys serve one sole purpose that is facilitating the deal, not blowing it.

(3) The locked box mechanism vs completion accounts mechanism

A recent trend in the United Kingdom and European M&A market is to use the "locked box" approach to determine the price for a target business in the context of a private M&A transaction instead of the conventional completion accounts approach. The primary difference between the two mechanisms “locked box” and “completion accounts” is the date of transfer of economic risk. When a completion accounts mechanism is used, the Acquirer will pay for the actual level of assets and debts of the target as at completion in accordance with a post-completion pricing adjustment. The final price is not known for some time after completion. In contrast, a locked box mechanism involves the parties agreeing a fixed equity price calculated using a recent historical balance sheet of the target prepared before the date of signing of the sale and purchase agreement. Cash, debt and working capital as at the date of the locked box reference accounts are therefore known by the parties at the time of signing and there is no post-completion adjustment. The economic risk and benefits of the business pass to the Acquirer from the date of the locked box reference accounts.

Each mechanism has advantages and disadvantages, some of which we summarize below. The pros and cons of completion accounts include: 

Pros for Seller: May speed up negotiations and conclusion of a deal as an Acquirer needs less comfort on the balance sheet before completion, and the Seller retains the economic benefit in the business including the profits right up until completion; Pros for Acquirer: Only pays for what it gets because price is adjusted, and in full control of business when compiling and checking completion accounts;

Cons for Seller: Less control over the adjustment process, takes economic risk of business up to completion, delay in ascertaining final price, and costs of preparing completion accounts and any potential disputes; Cons for Acquirer: Delay in ascertaining final price, and costs of preparation of completion accounts and any potential dispute.

The pros and cons of a locked box mechanism include:

Pros for Seller: Certainty of price, increased control over the process, simplicity and avoids cost of completion accounts; Pros for Acquirer: Certainty of price, simplicity and avoids cost of completion accounts;

Cons for Seller: Does not get full benefit from continued operation of business in the interim period, and post-locked box interest rate, if any, is often insufficient to compensate the Seller for the earnings of the target during the interim period; Cons for Acquirer: Enhanced due diligence (particularly financial) often necessary, increased reliance on warranties, risk of business deteriorating between locked box date and completion, need to debate items such as debt and working capital earlier in the sale and purchase process.

Key issues that arise using a locked box mechanism:

The sale and purchase agreement must provide for "leakage", being any transfer of value from the target business to the Seller or its connected parties between the locked box date and completion including, for example, dividends and other distributions, and management bonuses. The parties will need to negotiate what constitutes leakage and other categories of payment which are permitted (including, for example, inter-group payments in the ordinary course, agreed dividend payments, payroll). As a target business is priced as at the date of the relevant reference accounts and this is the date on which economic risk and reward passes to the Acquirer, Sellers may ask for a specified rate of interest on the equity price, particularly when disposing of a profitable business (given the level of profits generated would remain in the business unless otherwise agreed).

In our case, we provide our client a modified locked box mechanism for the transaction. We introduce a Base Day, on which all assets and debts are consolidated in a fixed number and on that day, we settle a Base Price based on the number generated from consolidated assets and debts of Target Company. Therefore, there will be a transition period between Base Day and Completion Day. Because that Target Company remains operating its business in the transition period, and this would lead to the number fluctuated till Completion Day, we create a working capital adjustment mechanism. In this mechanism, the final equity transfer price would be Base Price plus working capital adjustments in transition period. If both parties cooperate efficiently, the transition period may not last for long, therefore, in this way, we could lock the transaction in a certain transaction scheme and settle most of the equity transfer price, which could avoid uncertainty in the deal and is safe for both parties.

(4) Take advantage of Escrow Account

The most frequently argued issues with lawyer from other party are the payment schedule of equity transfer price and equity transfer registration. Both lawyers want the safest way to close the deal, the lawyer from Acquirer wants the equity transfer to be done with limited payment as soon as possible, however, the lawyer from Seller wants to receive as much the money as possible before equity transfer. It looks like this is unsolvable paradoxes before the launch of Escrow Account.

Escrow Account is a banking service from most of the banks. Both parties could jointly open an Escrow Account which is under control by both parties. Only with orders at the same time from both parties, the money in the Escrow Account could be released. Escrow Account provides a solution for the foresaid paradoxes. The Acquirer reimburses certain percent of equity transfer price into Escrow Account and Seller initiates equity transfer registration and after the completion is done, both parties agree to release the money in Escrow Account to Seller.

In the end, from Acquirer’s aspect, transparent and firm due diligence conducted by experienced attorneys prior to M&A transaction is necessary and the result from due diligence would provide tremendous help for attorneys to design transaction schemes and draft transaction documents. A complex cross-border M&A transaction will not only contain foresaid phrases also include but not limited to tax issues, foreign currency issues, authorities’ permissions or qualifications, anti-trust issues and so on. For the limitation of such context, we can not illustrate each of the issues in terms of a complex M&A transaction. Thank you for your attention, for more information, please do not hesitate to contact us.