Due Diligence - the First Step to M&A Business in China
This article is an extract from Chapter 8 (Mergers and Acquisitions) of “Chinese Commercial Law: A Practical Guide”. Published in October 2010 by Kluwer Law International, author Maarten Roos (Managing Director of R&P China Lawyers) wrote this book for foreign managers with operations in China. It is available through the publisher (www.kluwerlaw.com) or in online bookstores including www.amazon.com.
One of the key components of any transaction is a review of the target company or target assets through a due diligence investigation. The steps for due diligence on a Chinese company are mostly the same as elsewhere. The parties generally start by signing a letter of intent or memorandum or understanding, and an agreement of non-disclosure and confidentiality. Then due diligence checklists are drawn up by the different advisory teams of the foreign investor and provided to the target company’s management, which will prepare relevant documents and information accordingly and make these available for review. After studying the provided information, the advisory teams will further seek independent clarifications where necessary, and verify key information through interviews with management, investigations with government departments and commercial partners, and other available sources. The resulting due diligence report is used as a reference in further negotiations.
While processes may be similar, it is generally agreed that conducting a due diligence investigation on a Chinese company is much more complex than similar evaluations in Europe or the United States. One reason is that internal controls of companies in China are often less rigorous, making it more difficult to obtain relevant information. There are also fewer tools available to independently verify certain information. Moreover, legal non-compliance is common; in fact, it remains extremely rare to find a target company with no legal inconsistencies, i.e. one that presents the acquirer with no legal risk at all.
In most cases however, this need not form an insurmountable obstacle to an acquisition. Non-compliance issues are acknowledged to be an indivisible part of the Chinese legal landscape, and as long as they can be clearly mapped and are relatively minor, an investor may decide to accept them if arrangements are made to minimize the risks – whether through conditions precedent to resolve certain inconsistencies, or through comprehensive representations and warranties to cover any fall-out after the transaction has been completed. The value of due diligence in China is to understand the predicaments a foreign investor may encounter when running the acquired business, and to be able to make an informed decision on whether the benefits measure up to the legal, financial and commercial risks that the acquisition presents.
One significant hurdle in any due diligence investigation of a Chinese company is the need to convince the Chinese managers of the target company to disclose all relevant information. Non-disclosure and confidentiality agreements are oftentimes ineffective, meaning that Chinese personnel generally place little faith in these documents. Further, there is little incentive for managers to divulge problems for which they are themselves responsible. Consequently, full cooperation is often difficult to obtain and enforce, even with the full commitment of the target company’s owners. Therefore it is imperative that in the planning stages the foreign investor and its advisors carefully determine the goals of the due diligence investigation, and the concurrent scope and depth to which certain matters are to be investigated; that a plan is devised to work with these managers; and that this plan and the goals of the due diligence are communicated to the target company and its managers in a clear and non-threatening way.
Focus 8.4 Limited Due Diligences
Small- to medium-sized companies are often reluctant to pay for a comprehensive due diligence. Unfortunately, it is these companies that have the greatest need to conduct a proper legal, financial and commercial due diligence, as they have the most to lose if the company that is created by the transaction ends up in failure due to excessive liabilities or an ability to turn a profit.
In one case, a Singapore investor was considering the acquisition of the Guangzhou subsidiary of a major French-based multinational company. Possessing a lot of trust in the multinational’s corporate practices, the investor first determined the budget and asked us to focus on only those areas which we considered the most risky. While the resulting report was not comprehensive, it provided the investor with sufficient information to proceed with negotiations, and for us to build in sufficient representations and warranties in the Equity Purchase Agreement.
In some transactions, most efforts are focused on negotiating a good deal, while the due diligence only serves to confirm the company’s fundamentals. Limiting the due diligence is often a lot safer approach than to entirely skip over the due diligence, especially where the acquisition is of strategic importance to the acquirer’s business.
Ideally, the whole target company should be reviewed to the smallest detail; however, for many relatively small acquisitions, this is difficult to accomplish, not only because it would be very disruptive to the target company’s continued operations, but also due to high costs. One way to focus resources is to identify in advance those areas in which the acquirer is most interested, as well as those that are particularly relevant to the industry or legal environment in which the target operates. A limited due diligence can focus on those specific areas, and thus save resources that can then be used to follow up on and resolve any red-flags that are exposed. [Focus 8.4]
Where risks are identified, the seller can be petitioned to take appropriate actions to curb such risks prior to completing the transaction, or they can be accounted for in the transaction price or through the seller’s representations or warranties, the latter combined with indemnification and payment hold-back mechanisms that are common to Chinese M&A. Also, the acquirer can insist on severe repercussions for the seller in case of any liabilities that are not disclosed during the due diligence. Where major risks cannot be curbed or where a seller cannot accept penalty clauses for disclosure failures, a prospective acquirer should be ready to walk away from the deal.
A final point to be made is that a due diligence can cover different aspects of a target company’s status – most commonly the investigation is divided into commercial aspects, the company’s financial and tax position, and legal conditions that may affect the transaction. These aspects are often investigated by different advisory teams that fully grasp the technical issues involved. On the other hand, these teams should also be encouraged to work together and share their findings where these may impact one of the other aspects of the due diligence.