Why Legal Due Diligence?
In China, for outbound mergers and acquisitions (Outbound M&A) transactions, “legal due diligence” (Due Diligence) refers to the legal work and investigation undertaken by an investor’s U.S. counsel to review certain legal affairs and identify certain legal risks facing a target company’s business, assets and operations1.
In short, Due Diligence is about discovery and allocation of risks, both known and contingent. From Due Diligence, an investor can gain greater knowledge of the relevant industry, marketing, competition, management information and financial performance of the target company. After conducting Due Diligence, an investor can make an informed assessment of potential and contingent risks and rewards of its investment, and negotiate risks allocation between the target company and the investor in the definitive agreements.
Non-Disclosure Agreement and Due Diligence
Prior to initiating Due Diligence, the target company most likely will consider and request an investor to enter into a non-disclosure agreement (NDA).
An NDA will address the scope of recipients who can assess the confidential information of the target company, which will be on a “need to know” basis. Another purpose of an NDA is to prevent an investor from directly or indirectly soliciting or hiring away employees of the target company, disturbing the business operation, and stirring panic among employees, customers and suppliers of the target company. An NDA protects the confidentiality of the information disclosed by the target company to a potential investor and its professional advisers.
Discussion of Due Diligence
Categories of Due Diligence
In practice, a virtual data room is frequently set up for storing the Due Diligence documents to be disclosed by the target company to the investor. Due Diligence often includes the following types of documents to be reviewed by the investor.
(1) Legal Documents
The investor’s legal counsel will review corporate formation and governance documents, commercial contracts, SEC filings (if any) and tax filings, disputes or potential disputes, and litigation and liens searches of the target company. Most jurisdictions have made litigation and liens searches open to the public for free or with nominal charges. These corporate documents will prove the target company’s due existence, power, and authority to enter into a transaction, as well as the absence of any contractual restrictions on its sale and potential merger with the investor.
(2) Financial Information
During Due Diligence, the investor and its professional financial advisers will review the target company’s audited and management financial statements and projections. The investor will compare the projected numbers with the actual financial figures of the target company so as to ensure that the capital expenses of the target company are mutually recognized by the investor and the target company, and the book value of the target company will remain in a reasonably customary manner without substantial changes, straddling the execution date and the closing date, as well as following the closing date. Financial information is a critical factor which affects valuation of the target company.
Due Diligence focusing on environment areas tries to identify investigations relating to the air, water, water materials, pollution discharges, and property environmental issues in the ordinary operation of the target company. A target company engaged in manufacture is usually heavily regulated by environmental legislation. Often, environmental surveys and reports are conducted by an external party to protect the investor. For such concern, all environmental reports and audits should be reviewed by the investor.
(4) Social Benefits and Payments
Social benefits and payments are governed by the target company’s jurisdiction because employment laws are unique in each jurisdiction. In general, review of social benefits of the target company involves analysis of employee benefits, retirement plans, social insurance, and history of employment claims2. Employment-related liabilities have become one of the investors’ major concerns as they can be very costly. Hence, through Due Diligence, the investor aims to identify potential legal risks related to the target company’s failure to maintain and/or pay into relevant employee benefit accounts, labor disputes, and expatriate arrangements.
(5) Real Property
Due Diligence of real property mainly sheds lights on investigations of estate management and title chains. The investor will review and analyze whether the target company has good and marketable titles to all of its real properties. The investor’s counsel will conduct title searches and review all leases of the target company if such real properties are used in the target company’s ordinary course of business and are not self-owned. In the U.S., the counsel will also review title insurance documents.
(6) Intellectual Property
As another key aspect, the investor will search and analyze the ownership and use of the intellectual properties, including patents, trademarks and copyrights, whether they are registered or not with relevant governments, and the ownership of the know-how of the target company. The ownership of the target company’s intellectual property will be ascertained and the licensing-in, licensing-out, and cross-licensing agreements of the target company will be reviewed to ensure that the investor’s right to use such intellectual property will not be limited following the Outbound M&A transaction.
Issues in Due Diligence
(1) Contingent Liabilities
In addition to the above aspects, it is necessary to look into whether the target company is subject to any liabilities that are not reflected on its balance sheet and identify the contingent liabilities of the target company. Such contingent liabilities include, but are not limited to, litigation claims, government investigations of employment, environmental matters, antitrust, securities, tax audits, intellectual property matters, insurance scope disputes, and other disputes between shareholders, employees, suppliers, and the target company.
(2) “Golden Parachute”
In an Outbound M&A transaction, it is crucial to review the agreements between the target company and its management. Often, in order to discourage potential hostile takeovers, the management of a target company is protected under the “Golden Parachute” policy, by virtue of which a large amount of compensation will vest immediately in and be payable to the management if a change of control of the target company is triggered.
(3) Restrictions on Restructuring
A change of control provision is often contained in commercial contracts entered into by and between the target company and its suppliers or customers, employment agreements, joint venture agreements, government contracts, retirement plans, insurance policies, lease agreements, and financing agreements with banks.
It is necessary for the investor to identify if any of the contracts mentioned above contains a change of control provision, transfer restriction, or non-competition language. Usually, these contracts require written consent of or notice by the target company to a third party, and may contain certain prohibitions on or limit the restructure of the target company unless a third party agrees to lift such prohibitions.
If a change of control prohibition exists, the investor will require the target company to obtain written consent or give notice as a closing condition of the Outbound M&A transaction and will require the target company to remediate all known and overt legal risks to avoid a third party challenging the validity of the material contracts and the completion of the Outbound M&A transaction.
(4) Shareholders and Governments Approvals
In addition to reviewing all material contracts of the target company, an Outbound M&A transaction may trigger shareholders’ approvals and governmental authorities’ review and approvals.
In a standard shareholder agreement, preemptive right, right of first refusal, co-sale right, drag-along right, tag-along right, and other alike provisions are common. If such rights exist, the investor may need to address them. For example, the preemptive right vests in the target company’s existing shareholders a right to purchase any new issuance of shares by the target company on a pro rata basis so as to maintain their proportionate ownership in the target company. The existing shareholders of a target company may also have a right to purchase the shares of the target company prior to such shares being transferred to a third party under a right of first refusal provision. For the existing shareholders who are not willing to purchase any shares to be transferred to a third party, they may be entitled to elect to sell their proportionate shares together with the transferring shareholders under a co-sale right. The investor’s counsel needs to know and review all these rights.
In addition to obtaining the shareholders’ approval, the other questions that the investor and the target company should consider are which government agencies need to review and/or approve the Outbound M&A transaction and how long it will take for such government agencies to complete their review and/or issue the approvals. From China’s perspective, an Outbound M&A transaction always triggers governmental reviews and/or approvals of the National Development and Reform Commission, the Ministry of Commerce, and the State Administration of Foreign Exchange, or their branches at local levels, and it may take a couple of months for the investor to complete all such reviews and obtain approvals. From the target company’s perspective, approvals must be obtained from the relevant government authorities of its jurisdiction, for example, if the target company is a U.S. entity, an Outbound M&A transaction may be subject to approval of the Committee on Foreign Investment in the United States.
Interaction between Due Diligence and Transaction Documents
As aforementioned, Due Diligence is essential for the investor and the target company to identify and negotiate risks allocation in an Outbound M&A transaction. The definitive agreements are the vehicles for addressing and evidencing in writing the risks allocation between the investor and the target company.
A typical shares purchase agreement or shares transfer agreement is the key definitive document to include:
(i) the target company’s representations and warranties in respect of the areas discussed in Section III(A), which will contain detailed descriptions of the risks identified during Due Diligence as explained by the target company;
(ii) the conditions precedent that the target company has to complete prior to closing the Outbound M&A transaction to ensure that all potential risks have been remediated before closing; and
(iii) for those risks that may not be remediated prior to closing for various reasons, the remedies that the target company has to burden after the closing, which will include indemnification obligations if the target company breaches its representations and warranties, agreements and/or covenants in the definitive agreements.
Influence of Due Diligence after a Merger
For a successful Outbound M&A transaction, in addition to understanding the target company’s business and political environment, a thorough and meticulous Due Diligence is a cornerstone to allocate the known and contingent risks to yield an anticipated and promising result of synergy between the investor and the target company and prevent disputes in the future.
Due Diligence is key for the investor to identify legal risks and issues in the target company’s business and to clarify the risks allocation in the transaction documents. Due Diligence is a vital procedure to ultimately lead to a smooth convergence of the investor and the target company despite different cultures and economic backgrounds.