Corporate CounselThe Metropo l i tan

Volume 16, No. 1 © 2008 The Metropolitan Corporate Counsel, Inc. January 2008

®

As an increasingly powerful cylinder ofthe world’s economy engine, China continuesto attract significant influx of foreign capitalto fuel its growth spurt and witnesses an extra-ordinary period of cross-border mergers andacquisitions. In this turbulent yet rapidlyevolving market, however, making successfulinvestments and mastering the “art of thedeal” require a profound understanding of theunique risks and challenges as well as quickand creative adaptation to the local context.Such unique challenges for foreign acquirorsare often associated with one or more of thefollowing “risk factors”: a legal and regula-tory system that is in a state of flux, restric-tions and limitations on deal structures,unfamiliar customs and practices, and diffi-culty in discovering hidden liabilities andother problems.

This article highlights several key areas ofrisks associated with M&A transactions inChina, with the aim of helping dealmakersidentify and address important issues at anearly stage.

Navigating Through The Red Tape ForApproval

China’s regulatory environment is stillrated among the top concerns for U.S. compa-nies, according to a recent survey by the U.S.-China Business Council.1 An initial matter that

a foreign investor needs to assess in setting itsexpectation is how the Chinese regulatoryrestrictions may affect the structure andprocess of the deal, in particular, whether thetarget company, after being acquired by a for-eign investor, can continue to conduct its busi-ness and operations in the same mannerwithout becoming subject to additional regu-latory restrictions. There are still a number ofbusiness sectors in China that are not fullyopen for foreign investors, in which suchinvestors cannot establish wholly foreign-owned enterprises or even joint ventures. Aforeign investor should determine as early aspossible whether there are percentage limita-tions on its potential ownership in an enter-prise in a given industrial sector, as this willdirectly affect the deal structure.

Foreign companies investing in Chinahave to deal with the ambiguity of the law andcontradictory views of different governmentagencies and officials. These conditions fre-quently result from a combination of ever-changing laws and regulations and formal andinformal “implementation rules.” Unantici-

pated “hidden” rules, which can be created byboth governmental and quasi-governmentalagencies, can also present challenges. Forinstance, a property registration center2 mayemploy local unpublicized procedures thatrequire that share purchase agreements orequity transfer agreements be in a prescribedform.

There is no magic to avoid these landminesother than hard work and vigilance. Foreigninvestors and their counsel should thereforeresist the urge to make “innocent” assump-tions, and must do substantial homework todevelop a keen judgment on legal complianceand risk assessment in China.

Assessing The Assets And LiabilitiesIn China, the verification of the ownership

of assets can present substantial challenges.Publicly available information and govern-ment records, if they exist, may be inadequateor unreliable. For private companies, the inter-nal documentation is usually not well kept andorganized, and it may be insufficient to showwhat assets belong to whom. For the state-owned enterprises, the situation may not besignificantly better, and requests for informa-tion often meet with reluctance and the “state-owned” attitude of secrecy. One company’sassets might have been pledged for another’sbank borrowings, and the same assets mighthave been used multiple times for making(registered) capital contributions in differentcompanies.

Contingent and off-balance-sheet liabilitiesmay present another serious area of risk for thebuyers of Chinese companies. Typical areasfor potentially significant liability exposuresinclude tax, employment, legacy problems,and environmental issues.

Tax due diligence should be an integralpart of any buyer’s assessment of a Chinesecompany. Failure to capture irregular or illegaltax practices and quantify the associated hid-den liabilities and downside risks could lead toserious problems. In addition to resulting inoverstated financial projections and an inflatedpurchase price, latent problems in this area

The Risks Of The Deal – Managing M&A Transactions In China

www.metrocorpcounsel.com

Lefan Gong

Zhong Lun.

Please email the author at lefangong@zhonglun.com with questions about this article.

Dr. Lefan Gong is a partner in the Shanghaioffice of Zhong Lun Law Firm. He advises Fortune 500 companies andmultinational corporations in cross-bordertransactions, including mergers and acquisi-tions, joint ventures and commercial transac-tions in China. A frequent author on Chinalaw-related topics, he is admitted to practicein New York and in China. He received a Sci-ence Juris Doctor and LL.M. from the Univer-sity of Michigan Law School.

Lefan Gong

Volume 16, No. 1 © 2008 The Metropolitan Corporate Counsel, Inc. January 2008

hands. To minimize these risks, the buyershould fully engage its local teams (includingprivate investigators, if needed) to gather localintelligence and sniff out hidden issues asmuch as possible to understand the companyand assess the risks. If the “shadow of doubt”cannot be eliminated, then it may be necessaryto consider alternative courses of action.

Purchase Price And Closing MattersTo deal with uncertainties over valuation

and mitigate the risks associated with theacquired company, acquirors should carefullycraft a purchase agreement with an acceptablepayment arrangement (for the purchase price)that is workable under the PRC law.

Unlike M&A transactions in the U.S., inChina the options of escrow accounts andholdbacks are quite limited and unsatisfactorydue to regulatory constraints and an underde-veloped banking services market. The PRClaw requires a foreign investor to make pay-ment within three months after the issuance ofthe new business license of the acquired tar-get. The deadline may be extended, subject togovernment approval, but no less than 60 per-cent of the payment must be made within sixmonths of the issuance of the new businesslicense, and the balance must be made withinone year. This effectively means a holdbackarrangement, if any, cannot extend for morethan a year, which may not be long enough forthe buyer to discover contingent or hidden lia-bilities. As escrow is a fairly new concept tomany banks in China, they are reluctant to getinvolved in situations that may give rise topotential disputes. Although in some excep-tional cases banks are willing to accommodatethe transaction parties, such accommodationsmay well involve the assessment of hefty fees.If the transaction can be partially structuredoffshore and part of the payment can be madeto a bank account outside China, holdbacksand escrow for purchase price may be easierto arrange as they are no longer subject to Chi-nese regulatory constraints.

A creative earn-out arrangement can alsoserve as a mechanism to help the buyer miti-gate potential risk exposure arising from con-tingent liabilities. (It can also be used tobridge differences between a seller and buyerover the valuation of a company.) Forinstance, a buyer could agree to make an addi-tional payment several years after the closingif the venture achieves a specified earning tar-get and there has been no material breach ofrepresentations and warranties by the seller.

In addition to careful drafting to minimizethe risk of gamesmanship in defining thefinancial targets and calculations of earn-outpayments, special consideration needs to begiven to creating a mechanism that is enforce-able and practical under the PRC law. If anearn-out is treated as part of the purchase con-sideration, then it will be subject to the samepayment deadline applicable to the purchaseprice, which is within a year following theissuance of the new business license of the tar-

may result in future tax audits, assessmentsfor past-due taxes, and hefty penalties.

Despite the severe civil penalties and thepossibility of criminal prosecutions, it is notuncommon to discover tax evasion, aggres-sive and irregular accounting and tax prac-tices, and even tax fraud in a Chinesecompany. Some Chinese companies keep twoor more sets of books in order to understatetax exposures. Related-party transactions arecommonplace and sometimes are based onhandshakes and oral arrangements, with theresult that the transactions are neither docu-mented nor reflected in a company’s books.Through these transactions, profits may beshifted to domestic entities that are in a lossposition or to offshore entities such as those inHong Kong. If it is determined that a transac-tion has violated PRC transfer pricing laws,the company may have to pay back taxes andpenalties. Buyers should also keep in mindanother important aspect of Chinese tax law –there is generally no statute of limitations fortax liabilities. Awareness of this circumstancemay be particularly important when allocatingtax exposures and entering into related indem-nification or other arrangements.

Employment issues frequently arise whenthe target is a state-owned enterprise with sig-nificant labor redundancy. Major layoffsmight trigger worker protests and other socialunrest, thereby politicizing the transaction andattracting unwanted attention from the localgovernment authorities. Another frequentlyencountered issue is how much workforce thetarget company may reduce after the acquisi-tion. This is often a heavily negotiated issue,and the seller may even bring it up again at thelast minute, hoping the buyer will compro-mise. Given the political complications ofemployment matters, it would be prudent forthe buyer to take a firm stand about its posi-tion, negotiate relentlessly up front, and resistthe temptation to leave this issue behind forfuture “friendly discussion.” Once the deal isotherwise cut, discussions on cutting back theworkforce will likely be neither pleasant norfriendly.

Finally, one of the most difficult headachesfor potential buyers of Chinese companies isthe legacy issue inherited from former state-owned enterprises or created during the“reform and restructuring” (i.e., privatization)process. Buyers of privately owned compa-nies that were restructured or converted fromformer state-owned enterprises should be alertto possible violations and liabilities associatedwith the prior “restructurings” or managementbuyouts.

A normal due diligence investigation fre-quently will not reveal much in terms of suchlegacy problems, because any problematicelements of the company’s history will likelybe kept secret until a corruption scandal erupts– usually when a local official loses his job orgets investigated. In such cases, it frequentlyturns out that the seller does not have clean

get. Consequently, it is necessary to craft theearn-out language artfully to make sure thatany additional payment, in the eyes of regula-tory authorities and judges and arbitrators,does not constitute payment of a portion of thepurchase price. For instance, a buyer couldinstead agree to pay a consulting fee to theseller if certain liabilities are not triggeredwithin two years after the closing. However,the seller may be wary of the tax implicationsof such an arrangement.3

Another option is a buy-back arrangement,where the buyer can request that the sellerrepurchase the equity interests originally soldto the buyer at a fixed price upon the occur-rence of specified events, such as the com-pany’s failure to meet certain milestones ormaterial breaches of representations and war-ranties by the seller. But the enforceability ofsuch clauses remains to be tested, and theymay be subject to regulatory obstacles. First,such a buy-back will be subject to approvalagain when the change of shareholders needsto be effected, and there is no guarantee thatthe approval authorities will endorse therepurchase, especially when there is no clearguidance under the PRC law on how to dealwith such a situation. Second, the PRC EquityJoint Venture Law stipulates that unanimousapproval of the board of directors would berequired for matters such as mergers andacquisitions, and changes to the Articles ofAssociation. Thus, in the context of a jointventure, if the directors appointed by the“seller” refuse to approve the repurchase, it isan open question whether the foreign investorcan enforce such a clause in the PRC court toobtain board approval.

ConclusionForeign investors may face many potential

pitfalls when doing deals in China. However,with China’s robust economy continuing toattract capital, there will be more deals andmore competition in a changing legal and reg-ulatory environment. As a result, investorswill need to deal with these challenges in aninformed, flexible, and practical manner. Win-ning the game will require a deep understand-ing of the peculiarities of the Chinesepolitical, regulatory, and business environ-ment, coupled with the ability to adapt to theparticular circumstances presented. Experi-enced, creative, and practical counsel can pro-vide invaluable assistance in enablinginvestors to make informed decisions that bal-ance the risks and opportunities in the Chinamarket.

1 See Results of the 2006 USCBC Member PrioritiesSurvey, August 30, 2006, available at www.uschina.org/public/documents/2006/08/member-priorities-sur-vey.pdf.2 A quasi-governmental agency that is responsible forregistrations of leases and real property title, sale, andpurchase transactions, as well as monitoring theprocess of sale or auction of state-owned enterprises. 3 Depending on how the earn-out payment is treated fortax purposes, (e.g., capital gains, salary income, or“other labor income”), different tax rates may apply.