CITE Presentation-Legal Aspects of Mergers Acquisitions and Reorganizations-March 20,2012

©2012 Foley & Lardner LLP

CITE 12th Annual Conference

Legal Aspects of Mergers,Acquisitions and Reorganizations

James C. Chapman, PartnerFoley & Lardner LLP

March 19-20, 2012

EYE ON CHINA SERIES


Key Rules for M&A in China Rule #1 – “In China everything is possible but

nothing is easy.” Rule #2 – See Rule #1.


Level of M&a Activity in China 2011 Middle-Market Deal Volume.

– 1st half – 371 transactions – $30.3 billion.– 2nd half – 309 transactions – $20.4 billion.

2012 Middle-Market Deal Volume.– Feb. 2012 – M&A activity increased 19.77%

from January. – 2012 and 28.37% from activity over February

of 2011.


Factors Driving M&A Activity Continued growth in China. Desire of foreign companies to enter the China

market. Desire for foreign companies to gain market

share. Consolidation of key industries – auto parts,

cement and metals. Activity in high technology, clean technology

and sectors oriented toward Chinese consumer spending.


Goals of Chinese Companies Chinese companies desire technology,

managerial experience and new markets. Chinese companies offer resources, relationships

and knowledge on how to succeed in the domestic market characterized by:

– Intense competition.– Bureaucratic complexity.– Diverse regulations.– Varied consumer preferences.


Current M&A Environment

A recent survey by the American Chamber of Commerce – 2010-2011 China Business Report concluded:

– China remains a top destination for investment including M&A.

– 2/3 of respondents characterized the regulatory environment as either “not changing” or “deteriorating.”


Recent Regulatory Changes Affecting M&A Circular 59 – Issued by Ministry of Finance and

State Administration of Taxation to address special tax treatment of certain corporate restructuring transactions in light of China’s Enterprise Income tax law adopted in 2008 which was silent on the issue.

Notice No. 13 – SAT clarified tax treatment for asset restructuring transactions (March 2011).


Recent Regulatory Changes Affecting M&A (cont.) Notice No. 51 – SAT business tax treatment for

asset restructuring addresses restructuring transactions such as mergers, spin-offs, sale or swap of assets involving all or part of certain “qualified assets” (October 2011).

Notice of the General Office of the State Council on Establishing the Security Review Mechanism for Merger with the Acquisition of Domestic Enterprise by Foreign Investors – establishes a review mechanism concerning national security issues. (March 2011).


Roadmap for Completing a Deal Acquisition of a Chinese company is a long,

multi-step process often taking 18 months to complete.

Critical Steps:1. Selection of Target.

Substantial research for potential targets must be conducted including governmental policies in the target industry.


Roadmap for Completing a Deal (cont.)

2. Relationship Building.From the initial contact, foreign buyers should work to establish a friendly relationship with the selected Chinese target. Foreign buyers are encouraged to not only do business with Chinese partner from a pure money-making perspective, but also work on “jiao pengyou” or making true friends.

Role of “mian zi” or “face” – Very important and the Chinese feel embarrassed in taking advantage of a true friend. Foreigners are fair game.

Trust – A good relationship helps a foreign buyer win the Chinese target’s trust (to the extent possible), which makes business in China much easier.



3. Preliminary Due Diligence.Target’s value and market positions. Request and analyze information from the Chinese target and comparing such information with the buyer’s own independent research.

4. Letter of Intent.In Chinese deals, the letter of intent should be more detailed than in U.S. deals.

5. Complete Financial and Operational Due Diligence.A thorough due diligence includes, but not limited to the following (which is not intended to be an exhaustive list): (i) Assessing Financial Statements and Audits; (ii) Taxes and Filings; and (iii) Human Resources.



6. Complete Legal Due Diligence.

7. Acquisition Agreement and Related Documents.The period starting from the execution of relevant acquisition agreements to the closing of the deal is a sensitive stage for both parties. At this stage, the foreign buyer is not the legal owner of the target and has no control over the target’s business operation as the proposed deal is pending approval of the applicable Chinese government authorities.



8. Government Approvals.Unlike the United States, Chinese government agencies are active in every transaction. Every acquisition must go through various examination and approval procedures to consummate the deal.

9. Co-Management of the Target’s Corporate Seals.The procurement of the government approvals takes time. Buyer should consider negotiating a “co-management” agreement whereby the target will need the agreement of both parties to use the target’s corporate seals.



10. Closing.After the documents are signed and government approvals obtained, the parties may finally close the transaction.

11. Conversion of the Chinese Target to an FIE.After the closing, the target will be converted to either a wholly foreign owned enterprise or an equity joint venture.


Due Diligence“Where are the bodies buried” Key Problem Areas.

1. Ownership of the Target – practice of holding ownership in the names of others.

2. Financial records – 2 or 3 sets of books.3. Permits/licenses – many companies operate outside of

the scope of their permits.4. Ownership of Assets – often complex, no clear trail of

ownership.5. Tax payments – often negotiated, underpayment is the

rule.6. Bribery/illicit payments – are the rule not the exception.


Due Diligence Process

1. Background checks of the company, key owners and management – usually conducted by a third party investigation firm.

2. Management Questionnaires. 3. Facility Visits. 4. Meetings/conversations with third parties – tax

authorities and other governmental officials, customers, suppliers, current or former “partners.”

5. In-depth financial review. 6. IP Review – IP audit.7. Analysis of product development.


The Acquisition Agreement Key Limitations1. Structure of the Transaction. 2. Structure of the Purchase Price.

Cash. Equity – Must be freely traded on an overseas

exchange and meet other requirements; requires MOFCOM approval.

Earn-out –Difficult to use, rules require payment of purchase price within three months, can be extended to one year; requires MOFCOM approval.

Seller Financing/ Notes – difficult to use.

3. Indemnification and Holdbacks – Similar challenges to earnouts.


The Acquisition Agreement Key Limitations (cont.)4. Appraisal – Value of target’s equity or assets set

by an appraisal firm located in China.5. Non-competition – Can be attached to

employment agreement; limited to two year term; after expiration of employment agreement, buyer must pay compensation.

6. Governing Law – According to PRC law, cross-border acquisitions with a target in China may only be governed by Chinese law.


The Acquisition Agreement Key Limitations (cont.)6. Dispute Resolution – China is part of the New

York Convention which allows the enforcement of foreign arbitration awards in China. Hong Kong International Arbitration Center, Singapore International Arbitration Center are preferred forums.


Obstacles to Deals

The M&A landscape in China is full of obstacles including:

1. The laws and regulations are inconsistent and unclear.

2. Chinese companies lack transparency and due diligence is challenging.

3. The governmental examination and approval process is complicated and time-consuming.

4. Strict foreign currency control.


Key Challenges and Potential “Deal Breakers” In evaluating potential Chinese targets, there

are many challenges. 1. Lack of integrity of the target’s management. 2. The inability to establish clear title to assets. 3. High expectations of value. 4. Unreliability of financial statements, lax regulatory

compliance. 5. Ownership of the company itself. 6. Complex integration.


Chinese Government Approvals MOFCOM.

– National Security Review.– Anti-Monopoly Review. – Price and Terms Review - Deals over $300 million are

reviewed by Central Government office of MOFCOM. Under $300 million are reviewed by provincial or local branches of MOFCOM.

National Development and Reform Commission (NDRC) –applies to companies involved in manufacturing, equipment import or export, land use, real property, establishing or acquiring non-financial enterprises.


Chinese Government Approvals (cont.) National Development and Reform Commission

(NDRC) –applies to companies involved in manufacturing, equipment import or export, land use, real property, establishing or acquiring non-financial enterprises.

State Administration of Industry and Commerce (SAIC) – Issues the operating license.

Others – public security bureau, tax authorities, statistics bureau etc.


Differences Between U.S. and Chinese Acquisitions1. In China, the due diligence is much more

thorough, expensive and time consuming.2. The contractual protective devices available in

the US are not as readily available in China - escrows/holdbacks, notes, earnouts to offset against, indemnification.

3. Dispute resolution is not effective.4. Cultural differences such as lack of

transparency, unorthodox business practices, little interest in “win-win”.


Biography

Mr. James Chapman is a Partner in Foley & Lardner’s Silicon Valley office. His practice focuses on Mergers and Acquisitions, Venture Capital and Securities law. Mr. Chapman has been involved in over 250 Mergers, Acquisitions and financing transactions. He also has extensive experience in international business transactions. Mr. Chapman assists U.S. companies acquire China-based companies, structure investments in China and represents Chinese companies in public and private securities offerings in the U.S. Mr. Chapman is a frequent speaker at China-focused events and has been named as one of the top M&A attorneys in the U.S. by Legal 500. Email: [email protected]

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