China: Fraud Investigation and Practical Solutions in the Acquisition Process

Last Updated: 4 January 2011
Article by Mark Schaub Mergers and Acquisitions (M&A in China) is not simply win-win for owners and companies. It's also about win-win or win-lose for local governments. For example, small manufacturers provide jobs, taxes and gifts to local officials. If a larger manufacturer acquires a small one, jobs will move along with it. This is the main reason the industry is so spread out. No one wants to let go of jobs in their district. So what's your opinion on dealing with the local government in an M&A case?

Mr. Schaub: I think 95% of the projects, you know, the approval of authorities would be provincial or local governments. It's the first thing to remember. I think many foreign companies fail to properly engage with the local government. So it is very important before the projects to tell the governments why the project is happening, who you are, what you are doing. And you know, of course here in Shanghai, the local government doesn't care so much except for the very big projects. But if you are somewhere less developed they get very excited about any project. I think if a foreign company has a bit of a relationship with the local government, then if you have some problems with the work force, or you have a problem with the environmental authorities, or you have problems with other things, they can help you to resolve the problem smoothly. But if you only go to the local government when you have a problem, it may be a little more difficult, they will probably still help you but it is easier if you know them beforehand. People should try to build the relationship before you need them. The Ministry of Industry and Information Technology (MIIT) is drafting policies on mergers and acquisitions currently. The goal is to create a legal environment that encourages large scale M&A in the Chinese auto market. What' s the potential impact on M&A in China? Will it help to control the risk for the buyers?

Mr. Schaub: I don't think so. I don't know about these MIIT regulations. We' ve done some deals in automotive including major automotive transactions. Normally the NDRC (National Development and Reform Commission) is the main authority involved in the drafting policy. And the NDRC has set for quite a long time that China should consolidate its auto industry. So I don't know what happens to protect the foreign investors but I think basically the NDRC would like to see fewer but stronger Chinese automotive companies. I think the local government will be the loser in the consolidation, you know, if a Shanghai company takes over a major company in Nanjing you can guess which local government will be happy. I guess consolidation is definitely needed not just in automotive industry but also in other main sectors of the economy, so I think it is good for the Chinese economy if the government helps to consolidate. And a few clients not in automotive area but in other industries also want to consolidate the market because nobody can make money in the Chinese market if you have thousands of companies competing with each other. If you have five or six big ones then you will have the scale. If you look at the NDRC auto policy there has been a long term trend making it harder and harder for small companies to extend their production. I think they really want to help the big become bigger, I think that's the idea. There is going to be a lot of M&A activities over the year, especially in automotive industry. The 12th five-year plan on the automotive industry, the government encourages a lot of companies to do the M&A to make the big company bigger and stronger as you' ve mentioned. In the new wave of M&A initiatives, what are the main challenges in the M&A due diligence?

Mr. Schaub: In relation to Chinese state owned companies I think they have a different form of due diligence far from what the foreign investors do. It is more a political due diligence. They are mostly large state-owned companies. I don' t think I can really add too much on how they do the due diligence. If a private Chinese company acquires another Chinese private company, it is similar to a foreign company buying when it comes to doing due diligence. But if we are talking about big state-owned companies being consolidated, I don' t know how the due diligence process works. After the economic crisis, Chinese companies will buy more. One has to look at the the growth of Chinese investment on overseas markets. Maybe 20 years ago, there was virtually no foreign investment , nowadays 50 or 60 billion US dollars a year. So it is a rapidly growing development. But if you look it as a percentage of the world foreign investment, it's still only like 1% or something so it is important not to overstate but it is an interesting trend. You can see that the most of the investments today have been done by very big state-owned companies. So it's not like they are doing lots of 5 million dollar company acquisitions. These big companies are buying very large scale natural resource companies or rights. When the next level down in size of Chinese state-owned companies and private companies go overseas then I think it will be vital for law firms and lawyers to be involved. I think that at present having mostly very big deals like Geely's Volvo purchase is not great for lawyers except for those directly involved. You know, if we had a hundred smaller deals rather than one big deal then everybody can have a few deals. It is nice.

Overseas M&A for Chinese companies still present some challenges and I think it will take a little bit more time for Chinese companies to get used to implementing such deals. Often big projects are interestingly enough is easier to do than a small project. Because in a big project, there will be re people involved who know what they are doing. If it is a small project, there many not be resources available for the necessary expertise. That's one of the problems.

Another issue for Chinese companies is whether they currently really have human resources available to manage an American technology company? It is going to take some time. It will happen, but it won't happen next year. As for the fraud and risk management in M&A, such as the risks of informal arrangements and non-compliance in labor, tax, licenses and IP etc. here in China, are there common problems in other countries? What kind of suggestions you want to give for the Chinese companies as a seller to get a win-win business deal or as a buyer to bid for a successful outbound M&A case?

Mr. Schaub: China deals with private entrepreneurs there may be a higher rate of tax evasion and lack of payment of social contributions than most countries. You probably will not have such problems in Germany. However, in relation to fraud it is more difficult for me to judge, because you hear about foreign companies always talk about having zero tolerance. But when you look at the really huge kickback cases, it is not Chinese companies involved but rather large Western multinationals paying bribes throughout the world. So I don't think corruption is a problem just in China, I think it's a worldwide thing. What kind of suggestions you want to give for the M&A case for the Chinese companies as a seller to get a win-win business deal? And on the other hand, what are your suggestions on the Chinese companies as a buyer?

Mr. Schaub: First I want to advise that I do not believe there is a win-win in a M&A deal. Whatever, I pay more, you win and I lose, so I don' t think win-win can exist in acquisitions. If we take Chinese company as a seller, I think Chinese sellers will get a much bigger premium, if you would do your own due diligence in advance, have everything well-organized, and any obvious problems on non-compliance that you have, you explain upfront to the buyer. You know, even a very bad lawyer will find non-compliance on the social contributions or taxes. It will be better to disclose upfront maybe not full details, but you could give people what you do for due diligence and prepare your own documents. If you do the draft due diligence, the first draft, you will get to frame how the company looks. So I think that would be something useful for a vendor to do although I have never seen anyone do it yet I think it would be beneficial. I would guess you have a chance of a bigger premium because that makes people trust you immediately. It is much better to say: "We have these issues. Why do we have these issues? It is the standard local practice. All companies do this. We will be happy to introduce you to the local labor bureau and they can tell you it is not the law, but it is the practice and the case will not be a problem. And if you move towards compliance they will be happy".

That kind of approach would increase the chance of the deal happening greatly but you could also get a higher price you could imagine. I think the other thing is the focus on the contract. If I was a Chinese seller, I would only focus on one or two things. One thing is the price, and the payment terms. I would want to get as much as possible early on and I would try very hard to get 80% percent or more upon approval. Many people focus on representations and warranties and that is a wrong focus for a seller. I think it's really the payment and the payment terms. That's what I will be first interested in. And I would really insist on the share deal if possible, because the assets deal will make the transaction much more difficult. You will likely have much more taxes as well so I would imagine I would really insist on a share transfer if I was a Chinese seller.

Regarding on the Chinese buyers buying a company overseas, I think there should be three things. What I would be most worried about are the same things we tell foreign companies who come to China.

The first thing we should work out who they are. If you want to buy a company in France, you should work out firstly are you able to buy a company in France? You might have the money but do you have the ability to deal with a couple of hundreds of French workers - I don't know. Do you have the ability to implement the whole process or can you find people to help you? That would be my first question.

The second question will be look at the jurisdiction and try to get some people who are familiar with France to give advice. Of course the danger is always is if you have got people very familiar with the country, they may be too sympathetic to the country, and they cannot be very objective as to the county's shortcomings. So I think you need to have a very objective analysis of the county. Then I guess the third thing is, it is not just about the M&A deal, or the acquisition in buying a company, but about the real things that will follow. After I buy the company, what happens then? Do I have somebody to be sent there? Who do I send there? Do I have a French guy to send there? Or among the French staff at this moment, who will stay there? Now China has become the No.1 automotive market in the world. Do you think there will be large and increased M&A case or business trends?

Mr. Schaub: Actually No.1 automotive market doesn' t mean suddenly you get a prize or something. Obviously it is a world big market for the automotive industry. To tell you the truth I have less automotive transactions in the last couple of years. It seems to me that automotive was one of the first big waves of acquisitions or establishments by foreigners in China. That was back to be like early 90' s and mid 90's. It seems to me, every second deal we did was with the automotive components suppliers. I would guess, it has slowed down compared to other industries, because I guess a lot of the suppliers are already now in China. I think consolidation will happen among the big Chinese companies'. Because if you are a person making mufflers and you have a wholly foreign owned enterprise, I don' t think you will often buy a Chinese muffler company. If you are already here in China it may be easier for you to extend your factory than to buy a Chinese competitor, I would guess. I should mention new energy on batteries in automotive industry is an area where there is a lot of interest. That is one area we have seen many people talking about Chinese companies going overseas and people coming here, people doing batteries for cars. This seems to be a very hot area at present

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