What are the difficulties specific to conducting Due Diligence in China?
- The recent surge in acquisitions;
- The “chief’s culture…or lack thereof”; and
- Lack of transparency.
What is meant by the recent surge in acquisitions?
Acquisitions are a relatively new phenomenon in China, as the first acquisitions were made less than two decades ago.
In this context, even today, most Chinese companies still do not master the keys to conducting due diligence professionally. Despite this lack of skills, a large majority of Chinese companies have not acquired the reflex to seek external advice. As a result, it is not uncommon for due diligence, or even an entire transaction, to be conducted entirely in-house by people with little or no experience in the field.
- What is meant by “chief’s culture …or chief’s absence”?
A very large part of China’s economy is made up of private companies that are still run by their founder. Having started with nothing, these founders take great pride in their company’s success, identify fully with it, and ultimately see it as their own good.
In practice, this presence of the founder in the company leads to a very strong leader culture (“老板 – laoban” in Chinese) and to a more or less important confusion of his interests with those of the company.
Clearly, these particular characteristics do not fit well with the proper conduct of a Due Diligence.
For example, company executives will always be reluctant to communicate with a potential buyer without the prior approval of the founder. In the end, this results in the acquirer having the founder as its unique interlocutor, regardless of the importance of the subject matter. However, quite naturally, the founder will be reluctant to communicate information that could lead to questioning the validity of his management decisions (for example, typically, the hiring of a relative in a key position without the latter having the required skills, or the purchase of a property by the company for the exclusive use of the founder).
Confronted with the culture of the boss in private companies, the potential buyer of a public company will, on the contrary, be confronted with the absence of a boss. Indeed, the managerial organisation of public companies lead to a strong dilution of responsibilities. Moreover, given that there is limited information circulating in Chinese companies (see below), finding the right contact in a state-owned company with a cross-functional view of the business quickly becomes a real headache.
What is meant by lack of transparency?
A strong culture of secrecy exists in the operation of enterprises in China, certainly linked to the Chinese tradition that whoever holds information also holds power.
Communicating information in the context of due diligence is therefore an exercise that goes against the company’s usual way of operating.
This culture of secrecy is notably reflected in (i) the existence multiple sets of financial statements (only the founders finally know what the company earns) and (ii) the importance of oral agreements in areas where the potential buyer expects to find written contracts (especially with suppliers and customers). It is difficult in these circumstances to assess exactly the conditions under which the business operates.
Are confidentiality agreements a common practice?
As in other jurisdictions, it is common practice in China that the disclosure of information for due diligence purposes is subject to the prior signing of a confidentiality agreement.
In a manner specific to China, it is not uncommon for the seller to require from the buyer a reciprocal obligation to disclose information. This reciprocity is intended to ensure that the buyer undertakes to communicate, subject to confidentiality, the same information as the seller, concerning its organisation, accounts, activities, customers, etc.
While such a practice may be surprising (the communication of information is usually one-way, in the seller-buyer direction), it can be explained by a cultural concern for equality and reciprocity of obligations between the parties to a transaction (*).
In such a situation, the best strategy for the buyer is to limit the scope of the information provided to the vendor to certain very specific information.
Note:(*) It is worth mentioning the practice in China according to which all contracts, whatever their nature or subject matter, always begin with a preamble (although not mandatory under the applicable regulations) stating that “the parties entered into this agreement on the basis of fairness and mutual benefit”.
What are the usual precautions in terms of Due Diligence Checklist?
Many buyers ask the seller for a list of documents and information (“Due Diligence Checklist”) either based on an unsuitable foreign model, or formulated as broadly and generally as possible in the hope of not forgetting anything. In both cases, the Due Diligence List thus communicated only results in a waste of time.
For example, it is very common to see Due Diligence Checklist requesting the seller to transmit “any and all constitutive documents of the target companies and any amendments thereto“. And the buyer is then surprised to receive, at best, the Business Licenses of the companies in question…
It is simply not recommended to send the seller a broad Due Diligence Checklist. This would indeed require the seller to make an effort to think critically in order to assess which documents the buyer really needs. The practice of acquisition transactions in China, and more particularly of due diligence, shows that it is in most cases difficult for the buyer to avoid the need for a didactic effort to explain to the seller the documents he needs to conduct its due diligence.
It is therefore crucial to send to the seller a Due Diligence Checklist that lists very precisely all documents required taking into account the specificities of both Chinese law and the industry in which the seller operates.
Note: (*) For example, in the context of a Due Diligence on a company whose business requires specific licenses/authorizations, we recommend that the buyer identifies such license/authorizations and refer to them expressly in the Due Diligence Checklist. This approach will be more productive than simply asking the seller for “any and all licenses/authorizations/permits required for the conduct of the business”.
Are forged documents commonplace in China due diligences?
The production of false documents in the context of due diligence is not in itself a common practice.
Indeed, a seller who is reluctant to disclose information will generally pretend that he does not have the relevant documents.
However, when the buyer insists on the production of a document, and if the seller understands that the document in question is important to the buyer, then the risk of producing a false document becomes real. This is especially true when the vendor simply does not have the requested document.
A good example is the case of resolutions of the board of directors or the General Meeting. In the mentality of a seller in China, these resolutions are often perceived as unimportant since (i) major reorganizations (capital increase, change of shareholder) are in any case subject to registration with the competent authorities, and (ii) it is not common to keep a copy of the documents filed with such authorities. Conversely, in a buyer mentality, these documents are essential to reconstruct the history of a company and it is difficult to understand why they do not exist.
In practice, the false documents produced for the specific needs of a Due Diligence are generally of a poor quality.
Confronted to this problem, the buyer shall assess the possibility of continuing to cooperate with the seller in a climate of trust.
How is the data room organized?
With a few rare exceptions, it is not usual practice for the seller to set up a data room – physical or online. Thus, the documents on the Due Diligence Checklist are most often communicated by the seller as and when required, either in hard copy or by e-mail. It is therefore essential for the buyer to regularly update a list of received information and documents in order to avoid future conflicts over the documents transmitted (nature of the document, complete or not, dated or not, signed or not).
Is it possible to access certain information independently?
- Incorporation documents: articles of association, business license and other registrations (*), composition of the shareholding (in some cases), identity of the directors and the supervisor, etc.
- Registered capital: Amount of registered capital actually contributed by the shareholder (s).
- Real estate: verification of the regularity of the procedures for acquiring a piece of land (in certain provinces only), settlement of the purchase price for the land, title deeds to the land and/or buildings, existence of mortgages, etc.
What is the importance of "interviews" with managers?
In China, more than in other jurisdictions, meetings and “interviews” with the management of the target company are a primary source of information.
Indeed, the importance of oral agreements in the organisation of the business, in addition to the fact that domestic companies are not always well organised in terms of document archiving and conservation, make it difficult for the buyer to obtaining all the desired information in writing.
Face-to-face interviews with the management of the target company are the best solution to overcome this difficulty. The multiplication of these interviews makes it possible to ask the same questions several times and to several different persons and appreciate the consistency of the answers obtained.
These interviews generally take place with the managers of the various departments, and in the presence of the company’s founder (which is almost inevitable). It is recommended to keep a written record of the information exchanged during interviews and to have its content validated by the interviewee. This written record will be useful at the time of negotiating the representations and warranties.
When does Due Diligence end?
Part of the difficulty in carrying out acquisitions in China is that due diligence never really ends.
It is therefore very common for the seller to continue disclose information to the buyer, and for the buyer to continue to seek clarification for weeks or even months after the supposed completion of the due diligence, even though contract negotiations have reached an advanced stage.
In this context, foreign buyers are recommended to take a two-level approach in the context of China due diligences: (i) information that is crucial to the proper assessment of target company (and which should therefore be obtained in priority when the Due Diligence starts) and, (ii) information that is necessary but less important (and which may be obtained later during the acquisition process).