Common key red flags in Chinese legal due diligence

R&P China Lawyers


R&P is a unique Chinese law firm founded in 2010, offering trusted legal support for international businesses in China. They cover various sectors and have PRC-licensed lawyers representing clients in negotiations, dealings with government departments, and court proceedings. Their team combines local expertise with international experience, emphasizing integrity, communication, and responsiveness. With offices in Shanghai and Beijing, R&P engages in projects across China and collaborates with local firms for additional support, providing practical solutions for clients' legal challenges.
Discusses the most common issues noticed when completing legal due diligence on Chinese M&A targets.
China Corporate/Commercial Law
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Legal Due Diligence (LDD) in the context of an M&A project involves reviewing and assessing documents and information related to the target of an acquisition (Target). The usual approach is to have the Target prepare documents or files in response to a tailor-made LDD checklist. The result is usually a comprehensive picture of the Target and/or of critical issues of risk, so that the potential buyer can take these into consideration when deciding on the transaction, and negotiating price and terms.

Red Flags refer to any issues that appear inconsistent or abnormal within the given context, and therefore should prompt caution about the authenticity of the Target. This could include material agreements with change of control clauses or could result in contingent liabilities, external guarantees and related party transactions, and potential legal claims.

When completing LDDs on Chinese Targets for European and North American multinationals, we often come across the same kinds of issues. Here is a selection:

  1. Capital Contribution: The amended PRC Company Law will take effect on 1 July 2024 and requires shareholders to contribute registered capital within 5 years. This is a big change from the current (previous) law, which sets no time limits. Companies already established can enjoy a grace period. As failure to contribute can come with personal liabilities, it is important to confirm compliance on this topic (or take appropriate steps).
  2. Tax Liabilities and Financial Subsidies: Paying taxes is an important obligation in any country as failure to pay due taxes can lead to late fees and fines, while intentional tax evasion is a crime and could lead to criminal punishments for the company and senior management. On the other hand, the complexity of tax categories and changes in national policies often make it difficult to understand some of these obligations, for example with regard to fiscal subsidies or tax exemptions. Therefore, it is necessary to pay close attention to the completeness and compliance of tax payments, as well as the authenticity of financial subsidies.
  3. Employment and Social Insurance: Non-compliance with Chinese labor laws can have a big impact e.g., failure to sign a written contract will give the affected employee the right to claim for double wages. Therefore, it is important to review employment contracts, labor dispatch arrangements (if any) and company policies for compliance with the law. Additionally, it is not uncommon to see companies report lower salaries for the calculation of social insurance and housing fund contributions – another red flag that should be covered in the deal terms.
  4. Compliance with Data and Privacy laws: The PRC Personal Information Protection Law (PIPL) and the PRC Data Security Law govern the protection of personal information and data, especially with respect to cross-border transfer. The maximum penalty for failure to handle personal information in compliance with the law, is CNY 50 million (approx. USD 6.9 million) or 5% of the company's annual turnover of the previous year, while relevant managers can be penalized as well. Companies that handle a lot of personal information are the most obvious target, but almost every company in China has data privacy obligations under the law.
  5. Licenses and Approvals Required for Business: In China, many activities are still subject to special licenses or approvals by specialized government departments. Operating without such licenses can lead to penalties, an order to close the business, and even criminal liabilities for the company and senior management. In the context of M&A activity, it is crucial for the potential buyer to understand risks to the continued operation of a potential target.

There are of course many other areas that need review, and can result in red flags that a potential buyer will need to consider. The key to a successful legal due diligence project in China is to know what to look for, be sensitive to the information provided, and offer the potential buyer a balanced view of red flags, potential risks, and solutions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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