Due diligence: deal killer or deal saver? - International Law Office

Introduction
Types of due diligence
Procedure
Potential problems
Comment

Introduction

Every multinational company needs a China strategy. The country's resilient economic performance during the global downturn has made it even more attractive to overseas investors, but how should such companies arrive at a realistic appraisal of the potential risks and opportunities of a specific deal?

For many companies approaching a transaction, due diligence is a tool to confirm compliance or to seek confirmation that their project is not excessively risky. In the context of an acquisition in China, this is the wrong approach. Chinese companies are used to informal arrangements; as a result, non-compliance issues may arise in the fields of employment and social contributions, tax, licensing and intellectual property, among others. However, if a Chinese company raises no compliance issues, it is almost certainly not a viable option for a project - the target does not need the acquirer and the acquirer is unlikely to be able to afford the target. When properly performed, due diligence should uncover problems and compliance issues, but should go further and provide a plan - including price reductions, corrective measures and other steps - that allows for successful implementation.

A foreign company's ultimate decision maker may see little immediate opportunity in China, being reluctant to move hastily in a risky market and making full compliance a prerequisite for a deal. However, a visit to China can turn the most cautious chief executive officers into the most over-zealous converts. Due diligence plays its part in contextualizing a particular opportunity in the most practical terms.

Types of due diligence

A foreign investor normally starts conducting due diligence as soon as a letter of intent has been signed. This work is conducted in various ways:

• Legal due diligence is carried out by law firms, which check the legal status of the Chinese target, including its ownership structure, assets, operations and staff.
• Financial due diligence is carried out by accountancy firms to check compliance with accounting and financial requirements, and may overlap with a law firm's work.
• Investigatory due diligence is conducted by private investigation firms to check the good-faith basis of key management or business operations. This is normally necessary only in sensitive cases or to address serious concerns that are brought to light by financial or legal due diligence.
• Environmental due diligence is increasingly common. A law firm's research usually determines whether the target has the necessary environmental permits and operational licences, but it is based on documentation and interviews. In some cases a foreign investor also requires a technical assessment of a factory or other asset in order to assess its level of compliance. For example, soil sampling can determine whether the land involved in the deal is contaminated.

Procedure

The due diligence process follows an initial discussion with the client to gain an understanding of its industry, project and intended goal.

Strategy paper
A strategy paper should give a basic legal opinion on:

• the restrictions on the intended business (eg, whether a wholly owned foreign enterprise can be used and which operational licences are required);
• the potential advantages of incorporating a new company, including any preferential treatment available to a foreign investor on this basis; and
• operational requirements.

Preparation for fieldwork
Preparation for fieldwork should involve:

• liaising with other due diligence teams to minimize disruption to the target's organization and business;
• providing a list of documents for the target to prepare in advance; and
• making clear to the potential partner that cooperation with the due diligence process is a precondition of the deal.

Fieldwork
In the case of a Chinese target, due diligence that is confined to data rooms and document review is highly unlikely to result in useful findings for the acquirer, whereas direct research can be remarkably revealing. Ideally, fieldwork should involve:

• collecting documentation;
• interviewing members of the target's management, who may be surprisingly frank about the basis of its operations;
• cross-checking documents and visiting the relevant authorities, including the Real Estate Bureau, the State Administration for Industry and Commerce, the Commission of Foreign Trade and Economic Cooperation and the courts; and
• meeting stakeholders, including banks, customers and employees.

Picturing the target - an acquirer's checklist
In order to make a balanced decision about a transaction, an acquirer should have an overview of:

• the target's structure, including:
  • parties' agreements or board resolutions on amendments to the target's articles of association;
  • amendments to the shareholder agreement, if any;
  • business licences; and
  • an itemization of the parties' investment in the increased registered capital;
• the basis of the target's operations, potentially including:
  • approval from the State Administration of Foreign Exchange;
  • production or product licences;
  • environmental protection agency approvals;
  • pharmaceutical licences;
  • certification of tax registration;
  • land use rights and building certificates; and
  • documents relating to equipment and machinery;
• the target's contractual obligations, including:
  • agreements between the target and its shareholders;
  • loan agreements;
  • major supply and sales contracts; and
  • documentation on product distribution, technology, employees and accounts receivable; and
• the target's claims and potential liabilities, including:
  • pending outstanding debts;
  • claims or awards pending with courts or arbitration bodies;
  • discrepancies in audited accounts; and
  • ongoing investigations by government authorities.

Potential problems

A would-be acquirer must be prepared for difficulties in areas that might be taken for granted in a transaction outside China, and an examination of potential problems should start with the basics - it seems unlikely that a foreign investor would buy a non-existent company, but this has happened. Beyond disaster avoidance, an investor must consider whether the problems are irreparable or whether realistic solutions can be found.

Land use rights and buildings
Many Chinese companies operate on the basis of an informal arrangement with local authorities. An apparent owner may see no problem with pursuing a deal even if it has only a short-term, unenforceable buy-back agreement with the local municipal government, which remains the target's actual owner. Land or buildings may be mortgaged and the company may operate on the basis of allocated rather than commercial land use rights.

Assets
In addition to the issue of actual ownership, an assessment of assets must consider customs supervision, production know-how and third party rights (eg, mortgage or retention of title).

Operational issues
Acquirers should be aware that state-owned enterprises can obtain licences for commercial activities that are not open to foreign-invested enterprises; thus, the involvement of a foreign entity may result in licences being withheld or not renewed. Most companies do not apply Western standards of environmental performance and different standards apply to different enterprises.

IP rights
Although the approach to intellectual property in China has been changing fast in recent years, many Chinese targets value IP rights far less than a typical foreign acquirer would do, and may not even price them into the transaction. However, this approach demonstrates a less than rigorous approach to IP issues and often spells trouble. It is not unknown for a Chinese target to seek to sell technology in which it has no proprietary rights, and trademark and patent registrations must be cross-checked with official records.

Employment
Few Chinese companies can accurately claim to comply perfectly with labour obligations. In one transaction the due diligence report found that 220 of a target's 350 workers were classified as disabled, which enabled the company to take advantage of the value added tax exemption for certain enterprises employing disabled people as more than 50% of their staff. However, none of the employees actually performed work for the company; rather, the company's workers were found to be employed by a third party.

Comment

Although one purpose of due diligence may be to act as a corrective to 'deal destiny', a review of the potential pitfalls for M&A projects in China might be enough to dissuade some potential overseas investors entirely. Not all problems are surmountable and not all projects should proceed. Some risks may be legally remote but difficult to repair, and if a target is seriously flawed, the acquirer must be prepared to look elsewhere. However, many projects fail - or stall for long enough to allow a rival to swoop - because due diligence results are not read in context or because it is easier to list non-compliance issues than to remedy them. Firm but fair dealing with the target in the due diligence process and a clear message about the need for cooperation ensures that the process and results can be used properly: to reduce risk and optimize the legal structure of a deal. In this market in particular, it pays to be prepared.

For further information on this topic please contact Mark Schaub at King & Wood by telephone (+86 21 2412 6000), fax (+86 21 2412 6150) or email (schaub@kingandwood.com).