Due Diligence in China Just Got a Lot Harder: Now What?

With the wave of news surrounding due diligence company crackdowns in China, with Mintz Group and Bain & Co. as the highest profile targets to date (see here and here), a reporter reached out to inquire how legal practitioners are dealing with this diminished access. She wanted to know whether and how this complicates business relationships with Chinese companies.

Maintaining a Healthy Distance from China

At our firm, we have chosen to keep most of our attorneys outside China for a variety of reasons. Client files and our attorney work product remains on servers not accessible to the Chinese government. Our attorneys can think, work, and speak openly about the real China business environment without fear of reprisal. And our clients value our proximity to their home base of operations.

They (Were) Just Giving This Information Away!

I practiced domestic transactions in the U.S. for several years before starting to engage in international transactions, including with Chinese companies. I was initially surprised at the ease with which we could learn about so many aspects of our Chinese counterparts. These were the types of details that we normally could not learn about many U.S. and offshore companies. I was almost giddy in discovering that confidential information such as owner names, ownership percentages, management names and titles, and the status of various business-related permits were all readily available. We sometimes have even been able to get Chinese company tax returns from Chinese government databases, all 100% legally.

But Not All of the Important Information Was Easily Available

But China has not been a completely open book to this point in time. Some aspects of due diligence have long been and continue to be unavailable or at least not readily available, in contrast to the ease with which we can search in the U.S. These include liens and other encumbrances against real property (found in our county recorder office records), security claims against personal property (found in our state Uniform Commercial Code databases), as well as some litigation and regulatory actions (found in state and federal court records, as well as via general internet search engines), as well as criminal records.

It is true that the less information that is publicly available, the more difficult it will be to root out fraudsters in the early stages of a transaction, and that is concerning. But I do not know of any jurisdiction in the world where everything that you would ever want to know about a company and its owners is readily available. Each jurisdiction has its plusses and minuses. That is in the nature of doing business across borders.

But from a holistic international transaction standpoint, due diligence is only one half of the equation to help our clients identify and quantify their potential risks in doing business with their international partners.

Filling the Information Gap Through Contract Terms

The contracts that make up each international business deal will differ, sometimes significantly, based on the scope of the transaction. We approach joint venture agreements where parties become deeply enmeshed with each other quite differently from sale agreements where our clients are merely purchasing an off-the-shelf product.

But all well-written contracts require the Chinese counterparty to provide certain assurances regarding their operating history and their current status. In the legal world, we refer to these as “representations and warranties,” (R&W) and they feature prominently in every agreement (see here).

In essence, these are the provisions of the contract where each party promises they are the right business partner, have mitigated their own risks, and are ready, willing, and able to perform according to the contract’s terms. If any representation or warranty is inaccurate, that can be a basis for undoing the entire contract and restoring each party to its original position.

Filling the Information Gap Through Representations & Warranties Insurance

As you can imagine, in significant transactions the representations and warranties section of the contract can stretch on for pages – sometimes comprising more than ten pages in a fifty-page contract. These representations and warranties often include a company’s existence and good standing, its entity and asset ownership, its financial health, licenses, investigations and litigation, employment matters, potentially conflicting contracts, and even what management knows or has reason to know about why the transaction could fail.

How Will the Information Gap Affect Cross-Border Deals?

This shrinking due diligence vantage point will impact the way we do business in China and with Chinese companies. In terms of transaction mechanics, two things will become significantly more important: indemnity carveouts and R&W insurance.

Indemnity Provisions

Indemnity is the concept where each party agrees to “insure” the other party against deal risks that specifically relate to the inaccuracy of a R&W term. For instance, a Chinese seller may represent and warrant that it has an export permit. If that is not true, then the buyer or seller will need to contract with a third party in China with an export permit, adding tangible costs to the transaction. This additional cost would be covered by the seller under the contract’s indemnity provisions. A smart buyer would also include a contract provision that allowed it to hold back part of the purchase price throughout the life of the contract to hedge against this risk. Having said this, I do realize that the value of an indemnification provision depends on the financial health and viability of the Chinese company agreeing to indemnify and so to the extent that the ability to discern the finances of the Chinese company declines, the value of the indemnity provision could decline as well.

R&W Insurance

R&W insurance insures both parties (typically buyer-centric in an M&A transaction) and provides the initial indemnity payout to a certain threshold if one party’s R&W failure materially impairs the deal. R&W insurers are third parties to the transaction and base their coverage options on an R&W due diligence memo usually provided by the buyer’s legal counsel. In the future, R&W insurers may be less willing to provide coverage (or coverage at a reasonable cost) based on due diligence limitations.

Due to these limitations, which result in less trust on both sides, a party’s available collateral becomes much more important, both the size of the collateral and the ability to capitalize on it in the event of deal impairment or total failure.

The Interplay Between Indemnity Provisions and R&W Insurance

R&W insurance is usually only relevant in large-dollar M&A transactions (US$ 10MM+), but indemnity carve-outs appear in varying forms many contracts, especially international contracts where the parties do not know or trust each other. Normal trade/sale agreements or sales done by purchase orders (POs) will very rarely include these because buyers and sellers do not involve lawyers unless they have had deals go bad in the past. Indemnity set-asides (such as escrow amounts held by a third party) are only used in agreements involving large dollar amounts. These can be large and ongoing cross-border purchases or larger dollar M&A deals.

Why is the Chinese Government Cracking Down on Due Diligence Now?

China has always put up barriers to foreigners practicing Chinese law to keep its legal and business markets somewhat protected from foreign competition and to keep potentially troublesome, inquiring people like lawyers and reporters out of China’s vested business interests. I include the accessibility of important public company records in this definition of practicing Chinese law.

For example, even before these latest newsworthy developments, records that were ostensibly public records were difficult – if not nearly impossible – for non-native Chinese readers to access due to the Chinese-language security checks to prove you are a human rather than a computer program. But we have seen an acceleration in recent weeks of data accessible from relevant government sites and those that scrape data from government sites. Some of these were accessible from the U.S. but have been completely blocked without the use of a VPN.

But the Chinese government has taken it one step further to firewall this information behind an additional security check that requires a Chinese cell phone number. Fortunately, my law firm has Chinese cell phone numbers we can use to maintain our access to Chinese records, but I also think that China will continue limiting access for these people as well.

We can only assume that this more draconian step is to ensure that the Chinese government can always track down the Chinese national or foreigner in China performing this research so that they can apply pressure when it is politically or economically expedient. This is the essence of an open, welcoming economy with Chinese characteristics, and it is the reality of doing business in and with China in the next decade.

For more information, see:

Private Equity Deals Involving China Assets: Due Diligence and Normal Noncompliance

Foreign Company Due Diligence

Why China Deals Do Not Get Done