Risk Analysis: M&A Transactions in China

What are the key risks to doing M&A deals in China?

The exponential increase in the volume of M&A transactions involving Chinese companies since Deng Xiaoping opened China's doors to the international market is evidence that foreign investors see the potential rewards to be well worth the risks and challenges. What are these risks and how have some overcome them more successfully than others?

The most common risks associated with M&A deals in China generally relate to political or regulatory climate, the documented historical bribery and corruption risk, and the financial risk related to moving monies in and out of China, among other operational risks. In this chapter for GTDT Lexology's Practice Guide on China M&A, FRA forensic accountants with rich experience in M&A due diligence detail specific risks through concrete examples and discuss how awareness and planning can make for a more viable and rewarding investment.

Bribery and Corruption

Various reasons have been cited for bribery and corruption risks in China: restricted press, ambiguous interpretation of the law, burdensome bureaucracy and guanxi (relationships). Companies operating under enforced extraterritorial laws such as the Foreign Corrupt Practices Act (FCPA) or UK Bribery Act should be aware that many settlements have involved allegations of bribery and corruption in China. China's amendment to the Anti-Unfair Competition Law (2018) and its forthcoming implementation of a social credit system are signals that the government is trying to level the playing field.

• Successor liability risk. This is an overarching corruption risk as acquiring a company covered by the FCPA exposes the acquirer to potential liability for pre-acquisition acts. The DOJ and SEC's Resource Guide to the US FCPA emphasises the importance of pre-closing due diligence and post-closing integration of the target into the acquirer's compliance and internal control programmes.
• Third-party due diligence. In addition to bribery and corruption, third-party risks include fraud, money laundering and conflict of interest. A number of regulatory cases in the past few years have shown the punitive damages that can arise from failing to invest in robust due diligence on third parties.

Political and regulatory environment

Different risks may arise depending on the type of M&A investment, be it minority investments, joint ventures or majority-owned subsidiaries. These risks are further heightened when the majority equity owner or joint venture partners is a state-owned enterprise (SOE), as access to books and records, financial information and operations details can be significantly restricted.

• Data privacy regulations. A part of any M&A deal is access to data and this necessary access continues after the investment is made. Access to data brings its own set of risks and concerns both in and outside China; for example, China's national standard Personal Information Security Specification does not align in some areas with the EU GDPR. Investors need to be knowledgeable to avoid unintentional violations.
• Political climate. Regulatory changes - both operational and legal - impact business strategy. While China offers a relatively stable and centralised political environment, there have been signs of nervousness at the top levels of government, including over the impact of the Hong Kong protests. Government intervention can be challenging if a company is deemed not to be aligned with government policy, or it can be an advantage when new laws are implemented to protect foreign investors (i.e. the Foreign Investment Law).
• Trade wars, sanctions and anti-competition. The ongoing US-China trade war is one probable cause of a contraction in M&A activity in the first quarter of 2019, as it impacts more than just the two countries involved. While government involvement from an antitrust perspective is not uncommon in many countries, the Chinese government has historically had a higher incidence of intervention, exacerbated by the trade war.
• National secret considerations. When dealing with SOEs or handling information that may be deemed state secrets by the authorities, the State Secrecy Bureau and its counterparts retain maximum flexibility in determining what is a state secret. If information is not properly classified, both the recipient and the sender are at risk of prosecution.

Other financial risks

• Foreign currency transactions and profit repatriation. To maintain control over the fluctuation of its own currency, China's State Administration of Foreign Exchange (SAFE) imposes strict restrictions on the flow of monies both in and out of China. This makes it a difficult and lengthy process for monies to be remitted from China.
• Money laundering risks. As China's central bank has signalled its intent to strengthen international cooperation to curb cross-corder money laundering, foreign companies operating in China need to ensure the appropriate Know-Your-Customer procedures and controls are in place, specifically with regard to politically exposed persons (PEPs).

Steps to mitigate risk

One step to consider to mitigate the risks above is carefully considering the structure of the entity and how it suits the business strategy. Pre- and post-acquisition due diligence should include transaction testing to assess the verbal representations made by the target, including for third parties engaged. Experienced advisers who specialize in data protection regulations and state secrecy laws - including attorneys, accountants and data governance professionals - can support the appropriate handling of data to help avoid violations. As corruption is endemic in China, in-country operations should be closely monitored with regular audits to identify potential breaches of laws and regulations and to create a culture of compliance.

This chapter can be found in GTDT Lexology's Practice Guides: M&A China (2020).

Download the chapter here.

The full publication can be accessed here.