China Law Insight : China Business and Intellectual Property Lawyers & Attorneys : King & Wood Law Firm : IP, Arbitration, Litigation, Securities, Foreign Investment

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 problem should start with the basics - it seems unlikely that a foreign investor would buy a nonexistent 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 noncompliance
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.

“Legal Entity Work”
The NCA Circular recognized a three-point standard concerning “legal entity work.” I.e., creation of a “legal entity work” should at least satisfy three conditions: (i) supervised by the legal entity; (ii) developed according to the intentions of the legal entity; and (iii) the legal entity is responsible for the work.

This standard sheds some light on the issue but is far from clear. Point (ii) is especially difficult to apply due to uncertainties regarding a legal entity's intention. Three issues are often considered in practice to identify the existence of a legal entity's intention:
 

(a) Signature on the work. According to Article 11 [paragraph (4)] of the Copyright Law, so long as the legal entity’s name is mentioned in connection with a work and there is no proof to the contrary, the legal entity should be deemed to be the author of the work and therefore the work should have reflected the intention of legal entity.
 

(b) Content of the work. Does the content of the work likely reflect the legal entity’s intention or only the employee's own creative expression?
 

(c) The nature and purposes of the work. Given the nature and intended purposes of the work, in which party’s name will the work be published? For example, the advertising and explanatory materials created by a governmental agency for policy making, or an agency’s declaration or statement on certain events or actions (such as the “China's Situation in IPR Protection” issued by the Press Office of the State Council of PRC)—are all considered having reflected the intention of the legal entity.
 

“Occupational Work”
According to the NCA Circular, “occupational work” should meet two criteria: (i) the citizen who created the work should have an employment relationship with the legal entity; (ii) the work is created to fulfill tasks assigned by the legal entity employer. While criterion (i)--existence of employment relationship is to be decided in accordance with the labor law of China, Article 11 of the Implementation Regulations interpreted the term “work assignment” in criterion (ii) as –“a work within the scope of the duties that a citizen should fulfill for the legal entity or body.”
 

Two issues are often considered in practice to identify whether a work falls within the scope of the duties to be fulfilled by the employee: (a) whether the duties are specified in the employment contract or labor rules & regulations of the company, or reflected in the company's long term work planning; (b) whether the work has significant and direct correlations with the normal business of the legal entity employer.