M&A Agreements and the Challenges of PRC Acquirors

Ethan A. Klingsberg is a partner in the New York office of Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb publication by Mr. Klingsberg and Rob Gruszecki.

Companies based in the People’s Republic of China have committed to over $100 billion of overseas acquisitions since January 1, 2016, including a number of high profile targets in the United States and Europe. [1] The ties of these buyers to governmental entities in the PRC, coupled with the unpredictability of the PRC government, and the challenges that a non-PRC counterparty faces when seeking to enforce contractual obligations and non-PRC judgments in PRC courts has led practitioners to implement an array of innovative provisions in M&A Agreements.

Borrowing From the Private Equity Playbook

In the typical leveraged buyout by private equity fund sponsors since the mid-2000s, the acquiror vehicle that signs the M&A agreement is an unfunded shell company. In these scenarios, if there is a failure to close due to a risk allocated to the acquiror vehicle (such as failures to obtain regulatory clearances or the disbursement of acquisition financing) or a material breach by the acquiror vehicle (such as a failure to use the requisite efforts to cause disbursement of the financing or the failure to close when the closing conditions have been satisfied), then the target is able to be made whole through a combination of (a) contractually-specified liquidated damages amounts payable as reverse break-up fees and (b) a guaranty of the shell vehicle’s payment of these fees by the actual private equity fund which in turn has binding contribution commitments from its limited partners. In the case of PRC acquirors, even though these entities may be well-funded holding or operating companies rather than shell vehicles, it has become a common approach to include reverse break-up fee provisions similar to those in the financial sponsor LBOs and, in place of the sponsor guaranty seen in LBOs, to have escrow deposits secure the reverse break-up fee obligations. Here are some observations about the workings of these fee structures in acquisitions by PRC entities:

  • Recent reverse break-up fees accepted by PRC buyers have ranged in magnitude from approximately 3% to 9% of the enterprise value of the transaction (and in certain cases involving non-U.S. targets, more than 10%).
  • The required timing for the deposit of the escrows to secure the payment of these fees ranges from depositing the full amount concurrently with the signing of the M&A agreement, which is less common given the internal processes required for PRC entities to obtain hard currency (but insisted upon increasingly), to phased deposits over periods that extend up to several months after the initial signing and announcement of the execution of the M&A agreement (although often with some portion deposited at signing). In addition, in some cases, the deposit of the fee (or a portion thereof) is tied to the occurrence of a specific transaction-related event (e.g., election to extend the drop-dead date to continue to pursue a particular regulatory approval or receipt of target shareholder approval).
  • The escrow will typically cover 100% of the amount of the highest possible reverse break-up fee specified in the agreement (once all deposits have been made). Furthermore, in at least one instance involving a U.S. public company target, the agreement requires the acquiror to deposit the amount of the reverse break-up fee into escrow shortly after signing and thereafter to deposit the aggregate merger consideration three business days before the target’s shareholders meeting to approve the transaction.
  • The deposits are almost always in a Western currency and usually with a Western banking institution located in the jurisdiction of the target, although there are some situations where the parties have permitted portions of the deposits to be in renminbi and/or on deposit in banks in the mainland PRC or with the branch of a PRC bank in a Western jurisdiction.
  • The triggers for payment of these fees often include not only terminations as a result of failures of the PRC acquiror to perform the obligation to close when the closing conditions are satisfied and instances of similar material breaches by the PRC acquiror (including breaches of the escrow deposit covenants), but also a number of other instances, some of which are arguably specific to, or at least of heightened concern in the case of, PRC acquirors:
    • Failure of CFIUS to clear the transaction. Targets often favor reverse break-up fees as the contractual hammer to incentivize non-US acquirors to obtain CFIUS clearance in contrast to the provisions governing the allocation of antitrust clearance risk where targets are frequently satisfied with undertakings by the acquiror to make the concessions that the antitrust authorities require as a condition to clearance. The reason for the different treatment is that CFIUS authorities often are not forthcoming about what, if anything, could be done by the acquiror to make the transaction palatable. Thus, even if there were a way to specifically enforce a “hell or high water” covenant by the buyer to do whatever is necessary to obtain CFIUS clearance, the risk remains that the target would never be able to prove what is or was necessary to obtain CFIUS clearance due to the opaqueness of the process.
    • Failure of any PRC regulatory or PRC-based stock exchange authority to clear the transaction. The theory here is that these entities are indirectly affiliated with the PRC acquiror and therefore any failure on their parts to clear the transaction may be more attributable to old fashioned buyer’s remorse than a bona fide regulatory problem. In addition, the lack of transparency of these PRC regulatory authorities arguably makes it impractical for a non-PRC target, especially a publicly traded entity, to assume these execution risks. In many instances, the required PRC-related regulatory approvals that trigger the reverse break-up fee are specifically identified (e.g., MOFCOM, NDRC); however, in some agreements there is also a catch-all for any other regulatory approval related to the PRC.
    • Prohibition of the consummation of the transaction by a PRC governmental entity. The rationale for this trigger is the same as for the trigger relating to the failure to obtain requisite PRC regulatory clearances, but practitioners sometimes include the latter trigger but neglect to include the former trigger.

Reliance on Enforcement Without a Security Interest

Targets and sellers sometimes attempt to navigate the difficulties of enforcing obligations against a PRC acquiror by relying on more traditional enforcement mechanics in lieu of a security interest structure. Although the enforcement by PRC courts of judgments by U.S. state and federal courts can be challenging and uncertain, there is relatively reliable precedent for the enforcement by PRC courts of international arbitration awards obtained in accordance with the New York Convention. Still, the effectiveness of arbitration mechanics when all the counterparty’s meaningful assets are in mainland PRC hinges on the ultimate enforcement by PRC courts. Moreover, the use of arbitration for dispute resolution does not remove the arguments in favor of reverse termination fees to protect the target against failures to close arising from PRC legal impediments. Furthermore, arbitration provisions will not be helpful when a quick order of specific performance or other equitable relief against the PRC acquiror is needed to save the transaction. Some agreements try to combine dispute resolution provisions that specify the speedy and innovative Delaware Court of Chancery as the forum for specific performance and other equitable relief with provisions that specify arbitration as the forum for claims for damages. However, this approach may give rise to complications, since many disputes involve claims for both equitable relief and damages, and, in any event, this access to Delaware courts may well turn out to be of value only to the PRC acquiror when seeking equitable relief against the non-PRC target.

If the flood of sales to PRC acquirors continues, market practice on these points may become more uniform. But for now, as manifested by the chart at the link below, practice still varies significantly and non-PRC counterparties to PRC acquirors in M&A transactions will have to be thoughtful about how to manage execution and enforceability risks.

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To view the chart providing a brief overview of the terms of selected recent M&A transactions involving PRC acquirors, click here.

Endnotes:

[1] Source: Dealogic
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