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

V&T Law Firm | View firm profile

  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

(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”).
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

(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

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

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

(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

(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.

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