Due diligence strategies for overseas M&A

By Duan Min, Morgan Lewis & Bockius
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In overseas mergers and acquisitions (M&A), Chinese companies are often puzzled, or even upset, because of the major differences in the legal and regulatory environment between the target country and China. In practice, the legal department of a company often needs to conduct due diligence within a tight time schedule. How to identify crucial points as soon as possible in a short time, and communicate effectively with external lawyers, has been a challenge posed to in-house counsel. From the perspective of acquiring companies in Europe and the US, this article will discuss the difficulties and features in overseas due diligence tasks, and propose some ideas for solutions.

段民 Duan Min
段民 Duan Min

Ownership structure. The ownership structure and holdings of shareholders of a target company are the most basic items of a due diligence investigation. Chinese companies often hope they are able to find the exact answers from records in the relevant government departments. However, the government register in the place where the target company is located often keeps only some of the most preliminary and general items, without any complete information on ownership and holdings. In this case, in addition to the ownership documents – e.g. register of shareholders – provided by the other party, companies can check if there are omissions or inconsistencies from communications with major shareholders, creditors, management staff and major customers.

Details about ownership can be verified by reviewing financial statements, tax returns and finance documents of the target company, which often reflect the company’s equity and debt information. Minutes of board meetings also serve as a major basis of documents for European and US companies because many significant adjustments or changes to the ownership structure of companies require board approval.

Shareholders’ interests. Unlike Chinese companies, the shareholders’ interests of European and US companies are more complicated. This is particularly true for companies with financial investors, as they often issue preferred shares that involve a series of staggered rights and interests, convertible bonds, warrants and options. If a company is to be sold to an outsider, the holders of preferred shares are often entitled to great powers – including the right of veto – and various rights of priority in the allocation of the proceeds. If the negotiation team in the acquisition are the management or founders of the target company, who often do not hold preferred shares, the acquiring party should then review the company’s articles of association, shareholders’ agreement, voting agreement and other documents to identify the rights and interests of each of the shareholders and make sure no shareholders will challenge the legitimacy or fairness of the deal, so as not to block the deal or increase the costs of acquisition.

Intellectual property rights. As intellectual property rights are region-based, an acquiring party needs to assess whether it will conduct enquiries only about key markets – e.g. Europe and the US – according to the purpose of the acquisition and the nature of technology involved. If necessary, it also needs to form a team comprising patent lawyers, agents, appraisal firms and in-house technical staff. In practice, it should not overlook issues such as the payment of patent maintenance fees, the continuity of the chain formed by IP rights and the completeness of filed records. Given the special nature of patents, it is also very important to make sure whether a patented technology can be freely applied without the constraints of any third party patent. If necessary, the acquiring party needs to conduct a special “free to operate” (FTO) analysis, or even require a lawyer to present an FTO opinion.

Labour issues. Given the complexity of labour and employment laws governing European and US companies, it is necessary to conduct a detailed assessment of issues like trade unions, collective contracts, pensions and employee benefits, to obtain sufficient understanding of the operation costs and risks after the acquisition. In addition, the executives of a target company often hold equity interests of the company in various forms. In the event of a takeover, vesting of these options or equities may be accelerated, which will likely lead to an increase in the acquisition cost.

Pledge, mortgage and immovable property. Europe and the US have a developed, comprehensive and authoritative search system under which a third-party professional agency, at the request of the acquiring party, can conduct a basic search with the payment of a small fee. If an immovable property is located in a sensitive place, it is sometimes necessary to conduct a field visit. Taking the US as an example, an immovable property to be acquired by a foreign company was located close to a navy training base in the US. The Committee on Foreign Investment in the United States required the acquiring party to carve out the property, and still rejected the entire deal on grounds of national security. This might have been avoided if a field visit had been paid in advance.

Major contracts. In addition to investment and financing contracts, major contracts for procurement, sales and technologies are also the focus of a due diligence process. Under these contracts, restrictions will sometimes be imposed on their transferability and change in control of the counterparties. An acquiring party needs to analyse the consequences of such restrictions, and where necessary require the target company to communicate with the contract parties in a timely fashion.

Finally, due diligence should be closely connected with the purpose of a transaction, and even follow-up plans. If a company plans to transfer the technology of a target company to China, it should consider various issues such as layoffs of staff, filing status of the patent in China, geographical restrictions on licensed patents and sub-licensing restrictions, export controls by the target country and tax burden arising from the transfer of significant technology.

In conclusion, if issues and risks are identified during a due diligence process, the acquiring party can take various measures, including requesting the counterparty to make corrections before signing the contract and make representations and warranties in the transaction documents, or imposing closing conditions. For matters bearing contingent risks, the acquiring party may consider the issue of a legal opinion by a reputable law firm. As to the terms of payment, risks may be controlled by means of instalments, holdback, escrow account and even an earn-out arrangement. The design of risk control clauses should be fine-tuned according to the findings of the due diligence investigation and the circumstances of the transaction.

Duan Min is a partner at Morgan Lewis & Bockius in Beijing. He can be contacted at +86 10 5876 3686 or by email at [email protected]