Arbitration clause risks in M&A transition agreements

By Philip Qiao, East & Concord Partners
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Transnational asset purchase has become a more common commercial act in China in recent years. Like share purchase, such a transaction features a large amount, a complex structure, and often has a merger and acquisition (M&A) transition period, which is uncommon for other M&A transactions.

乔焕然-Philip-Qiao-天达共和律师事务所-合伙人-Partner-East-&-Concord-Partners-s
PHILIP QIAO
Partner
East & Concord Partners

The M&A transition period is set often because both the seller and the acquirer wish to realize their business model adjustments through the transaction. Arranging a reasonable period for the transfer between both parties will facilitate a smooth transition for the transaction. Lawyers have to pay very careful attention to the M&A transition period, a special transaction mechanism in designing and handling the framework and details of such transactions, and accordingly design a special “transition period agreement”. Through details of a case, this article focuses on the arbitration clauses of the transition period agreement, with a brief discussion on two potential hidden risks and corresponding suggestions.

Case briefing

An asset M&A agreement (the asset purchase agreement) in both Chinese and English was signed by and between Chinese company A and Chinese company B in 2012. The agreement specified that company A shall sell to company B a certain product line, for which party B shall pay an amount of US$225 million. A part of the product line under obligations of party A is located in mainland China, while the other part of the product line is located in Germany.

Under the asset purchase agreement, a service agreement for the transition period (the transitional agreement) was also signed by the parties, which specifies that within a two-year transition period, company A shall provide company B with transitional services, acting as an agent of company B in purchasing materials from other entities, processing and sale, so as to promote the completion of smooth transfer of subject matters including the production line, suppliers, employees, customers and intellectual property rights, and company B shall undertake the relevant costs and taxes.

In the arbitration clause of the asset purchase agreement, both parties agreed that “any dispute in relation to this agreement shall be settled in Beijing by the China International Economic and Trade Arbitration Commission”. In the transitional agreement, both parties agreed that “if any dispute arising out of this agreement, either party may submit the dispute to the China International Economic and Trade Arbitration Commission in Beijing for settlement.” In a market downturn after the signature of the agreements, company B poached employees of company A and refused to pay the transaction price. More seriously, a lawsuit was filed in the court by company C, a shareholder of company B, against company B due to company B’s failure to meet the performance target for company C, which caused company B to face the crisis of bankruptcy. In addition, during the term of the transitional agreement, companies A, B and C signed a statement of account with regard to the subject matter of the transaction located in Germany, which confirmed that company C owed company A an amount of US$50 million arising during the transactional period in relation to the subject matter located in Germany.

From the perspective of company A, the author believes that attention shall be paid to at least two risks.

Arbitration clauses shall be consistent with each other and definitely reflect the intentions of the parties. In this case, the asset purchase agreement had set out a valid arbitration clause between both parties, which definitely reflected the intentions of both parties. However, in the arbitration clause of the transitional agreement between the parties, the expression “all… shall” was replaced by “may”, which provided an excuse for company B and also caused the arbitration tribunal to question the jurisdiction. In fact, in the case, after company A’s initiation of arbitration against company B, company B filed a lawsuit requesting the court to hold the arbitration clause invalid on the ground that the arbitration clauses were inconsistent, leading to the need for legal interpretation.

Arbitration clauses shall cover both the contract signature stage and the contract performance stage. In this case, although there were cross-border factors involved, focus shall be drawn to the consistency of dispute settlement methods. In accordance with arbitration law principles, the jurisdiction under arbitration laws is derived from agreements between parties to an arbitration agreement, without any system similar to the “third party system” in legal proceedings. Therefore, so long as parties concerned are not parties to an arbitration agreement, there is no jurisdiction over arbitral proceedings. In this case, after the above-mentioned first issue had been settled, there was a valid arbitration jurisdiction over company B at the transitional agreement signature stage, causing company B to perform its payment obligations.

However, during the performance of the transitional agreement, company A signed the statement of account with company C with regard to the part of the product line located in Germany, thus leading to the transfer to company C, the payment obligation that should have been performed by company B. This made it difficult for company A to make a claim against company B for the debt of US$50 million under the transitional agreement through arbitral proceedings, and as a consequence, company A had to consider making a claim against company C through litigation proceedings. Therefore, the author suggests that in concluding an arbitration clause, parties concerned should take the agreement performance stage into consideration to subject the whole process under the agreement to the arbitral jurisdiction, so as to avoid unnecessary problems.

In addition to the above-mentioned risks in arbitration clauses, there were many other matters that needed to be reviewed by lawyers of company A in terms of operation of substantive laws. For example, the lawyers could have designed a “title retention clause” in advance to cope with the bankruptcy risk of company B in an economic downturn with a “bankruptcy exemption right (or priority of claim)”. For another example, with regard to the possible poaching of employees by company B after the signature of the agreement, the lawyers could have designed a “non-solicitation clause”, which set out relevant damages for breach, so as to prevent potential breaches by company B. In a word, legal services for transnational asset purchase are a systematic project in which lawyers shall consider and handle with great patience and care. Arbitration clauses involved shall be at least clear, valid and complete.

Philip Qiao is a partner at East & Concord Partners

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