THE TAKEWAY

 
Following “the Silk Road Economic Belt and the 21st-Century Maritime Silk Road” initiative of the Chinese government, Chinese enterprises' cross-border investment is just unfolding. This article aims to evoke responses and thoughts in the readers through legal analysis on due diligence, taxation, transaction contract and business negotiation in aspect of risk control during several cross-border investments by Chinese enterprises in 2016 - 2017 (from buyer's point of view).
 
 

THE RUNDOWN

 
Risk control in cross-border investment, also known as overseas merger and acquisition, includes transaction planning, selection of transaction parties, due diligence, transaction contracts, transition period, transaction integration, and persistent operation. Complexity of the implementation details throughout the whole process differs as far as countries and industries under investment are considered. 
 
Legal aspects covered in this article are: (1) Due diligence ("DD") and relevant taxations. DD is to prevent risks after the transaction plan is confirmed and transaction party is selected. Taxation planning for cross-border investment largely depends on the findings of the DD on taxation. (2) Transaction contracts and negotiation. Rights and obligations of the buyer and the seller agreed in the transaction contract aim to prevent the major risks after DD. For buyer's rights and interests, it is crucial to estimate seller's intention accurately and make proper negotiation strategies according to the characteristics of different industries and target companies.
 

THE BREAKDOWN

 
1. Due diligence
 
DD for cross-border investment aims to fully disclose information of the target company to estimate its value, and provide references for transaction decisions, structure design and negotiation. However, different cultures, customs and legal backgrounds between transaction parties often cause miscommunication and misunderstanding, and for Chinese buyers this means increased complexity and greater risks than that of domestic investment. For this reason, to reduce the risks, detailed DD is particularly important. Due to words limit, this article will introduce four key points in focus of the due diligence for a cross-border investment recently completed by the author together with foreign colleagues, company's business and finance departments.
 
 

1. Target company's equity structure

 
Generally, to mitigate risks, hide debts, raise funds or avoid tax etc, overseas buyers will set up companies with special purposes of different levels. A company as such doesn't have actual business but it may have an operating company of lower level to carry out projects. Moreover, in actual DD, overseas buyers usually can't provide all materials and information requested by the buyer or its external consultant. In such case, the Chinese buyer may consider asking the seller and their actual controller to mortgage their real estate, pledge their stock and provide guarantee, or reduce transaction price, extend payment period, pay byinstallments, increase final payment; they may also think about the buyer's payment being invested to the target company as shareholder's loan to minimize the risk when the buyer complicates the equity structure and sets up companies of different levels for special purposes.
 
 

2. Target company's debt and financing structure

 
If the target company is found to be a company of one or more levels with special purposes during the DD, normally this company has a large amount of loan, pledge of stock rights or mortgage of real estate. The aforementioned situation, if not found, will mean a huge risk to the Chinese buyer. The Chinese buyer cannot only ask the target company or their associated company's stakeholder, actual controller to provide pledge of stock rights and mortgage of real estate, but also claim in the transaction file that the seller should release the pledge or mortgage and repay the debts before the settlement. The buyer's rights and interests can be protected to the utmost by the above legal means. However, in similar cases of some projects, the seller usually cannot promise to repay all the target company's debts before the transaction. But the buyer may lower own business risks through equity financing with loan risks according to their own business strategy plan after deciding to acquire the target company.
 
 

3. Taxation

 
Taxation investigation and evaluation during DD have a huge impact on the acquisition decision and taxation plan before and after the transaction. During the DD with taxation experts from home and abroad, not only should some general taxation issues of the target company be evaluated, for example, whether the account book is complete with actual records, whether the expense can be deducted according the target country's laws and regulations, whether the tax is paid on time, whether taxation adjustment is available, whether taxation schedule is reasonable, whether tax fraud is found, whether the target company's taxation is recorded truly and scientifically in relevant audit report according to international code of conduct, but also should the target country's taxation policy for the target company's main business be focused on, as well as whether transfer pricing is relevant to the target company's cross-border business and may cause relevant taxation risks, whether changes to the target company's shareholders or actual controllers will cause taxation risks etc. If the buyer can understand the target company's taxation further, to protect their own rights and interests, they can adjust the acquisition consideration or agree on the compensation clauses in the transaction file. 
 
 

4. Valuation

 
Evaluation of the target enterprise's value according to the DD result is one of the most significant and frequently encountered issues during enterprise acquisition and foreign investment. An applicable valuation method is crucial because of the differences in industries, in countries and in enterprise scales. The author found EV/EBITDA a valuation recommended the most by finance experts from home and abroad, according to which multiple is selected based on data of the same industry. In addition, in many cross-border investments, cash flow investigation method is the most popular to define how to allocate profits, for the reason that: The cash-flow study indicates all costs and revenues, and the target company can use it as a basis to define margin distribution and bonus/bonus distribution in case of additional margin. This method is going to appreciably simplify the definition of the objectives, the margin calculation and the margin distribution among shareholders. Such method needs further discussion among finance, taxation and legal experts whether the method applies to profit calculation for target companies of different industries.
 
2. Transaction contracts and negotiation
 
Right and interest clauses in the transaction contract between the buyer and the seller are to prevent risks after the due diligence. Take, for example, the author's recent cross-border investment project for an international company based in China, the major controversial points, when stock right transfer agreement, shareholders' agreement and pledge of stock rights were drafted and modified by the author and foreign peers, and when the author negotiated with the business people and lawyer of the target company, are:
 
1) Whether payment adjustment mechanism or custody account mechanism is set up in the transaction file;
2) Whether payment schedule can be by installments after equity delivery;
3) Whether independent guarantee mechanism is mandatory for major risks disclosed by due diligence;
4) Whether to set up the threshold of damage for the buyer's claim for compensation;
5) Whether to set up a leeway in the transaction contract besides investigating the buyer's and the seller's liabilities of breach of contract; 
6) Profit allocation between both parties;
7) Appointment of board chairman, general manager and finance director in the joint venture company;
8) Joint venture company's financial policy;
9) Voting procedure, voting quorum, board of shareholders' rights and interests, whether shareholder or shareholder with certain kinds of stocks has casting vote.
10) How to handle a deadlock? What if the board of shareholders and board of directors can't reach an agreement on the main issues of the joint venture company for a long time? Should the deadlock be first escalated to the senior executive of the joint venture company for resolution? Or should the deadlock be judged by the board chairman, independent director or the independent third party?
11) Situation, category, redeem and consequence of breach of contract;
12) Under the protection mechanism of the buyer's rights and interests, in addition to the target company's real estate, should the seller's real estate or their (if it's a company) legal representative's real estate be mortgaged?
 
For business negotiation, it's suggested to have a team of business people (industry experts), finance personnel, internal and external legal counsels to cover the updates and trends of the industry, enterprise valuation, profit expectation and legal knowledge. It would be helpful to the success of the negotiation and the transaction if the above team know about the differences between overseas and domestic cultures and ways of communication.
 
In addition, under the win-win situation, the buyer and the seller should also consider the interests of the target company's management team, employees, customers, industrial administration, and local government etc, and keep a good communication channel to push forward the investment for a favorable result.
 
 

Conclusion

 
Cross-border investment is a 'cumbersome' process to reach an agreement upon cooperation among multiple parties. Due diligence, transaction file drafting and negotiation are the most important parts with lots of potential legal risks. It's lawyers' task to consider how to mitigate risks and gain cooperation and development with maximum benefits when supporting the Chinese enterprises through cross-border investment. There's an old Chinese saying, "The road ahead is long and rugged，but I'm determined to explore it myself", as an encouragement for our endeavors.
 
 
Author Bio
 
MsXin (Lilian) Liang, Partner &Head of Outbound Investment PracticeDept of Gengfu Law Firm.  In 2016 -2017, Ms Liang's team worked on several cross-border investment/acquisition projects for the Chinese enterprises and accumulated the latest experience. In Ms Liang's 13 years of legal practice, she worked in Total, CNOOC, Huaneng Group's Sino-American joint venture fund managementcompany, BMW's first foreign-invested car dealer and many famous Chinese and overseas enterprises, and provided highly effective legal services as these enterprises' internal or external legal counsel/legal and compliance manager. Ms Liang also worked in Judge's Office in Intermediate People's Court to support the judge to hear lots of finance and economic cases. Ms Liang is now the member of Asset Management Association of China (AMAC), Society of Petroleum Engineers, the United Kingdom and Chinese Law Association, Association of Corporate Counsel (ACC), China Lawyers’ Association and Beijing Lawyers’ Association. She graduated in well-known law universities in China and UK, and is studying cross-cultural communication while working. Ms Liang has a lawyer's license and fund qualification certificate in China; she speaks excellent Chinese and English, and basic French and German.
 
 
Author Bio
 
Ms. Xin (Lilian) LIANG, Partner & Head of Outbound Investment Practice Dept of Geng Fu Law Firm Beijing Office. In 2016-2017, Ms. Liang’s team worked on several cross-border investment/acquisition projects for the Chinese enterprises and accumulated the latest experience. In Ms. Liang’s 13 years of legal practice, she worked for Total, CNOOC, Huaneng Group’s Sino-American joint venture asset management company, BMW’s first foreign-invested car dealer and many famous Chinese and overseas enterprises, and provided highly effective legal services as these enterprises’ internal or external legal counsel or external legal counsel/head of legal and compliance. Ms. Liang also worked in Judge’s office in Intermediate People’s Court to support the judge to hear lots of finance and economic cases. Ms. Liang is now the member of Asset Management Association of China (AMAC), Society of Petroleum Engineers, the United Kingdom and Chinese Law Association, Association of Corporate Counsel (ACC), China Lawyers’ Association and Beijing Lawyers’ Association. She graduated in well-known law schools of the universities in China and UK, and is studying cross-cultural communication while working. Ms. Liang has a lawyer’s license and fund qualification certificate in China; she speaks excellent Chinese and English, and basic French and German.
 
Author’s Contact Information:
Ms. Xin (Lilian) LIANG 梁鑫女士
電話/Cell phone：+86 13718763094
電子郵件/E-mail:lilian.liangxin@hotmail.com
 
 
Related Resources
 
The author's five cross-border investment projects in 2016 - 2017.