Due diligence is essential when acquiring a company or making a significant investment in China. Much of the challenge has to do with the country’s relative opacity and its fast-paced, proactive approach to regulation. In this article, we will introduce a process for meeting these challenges head on, looking closely at what due diligence checklists should contain, how to get certain kinds of information, and how interviews with managers and government regulators should be done.
Successful China Due Diligence Starts with a Clear Checklist
Interview Executives in China to Verify the Documents are Accurate
Review China Government Filings to Avoid Surprises
Real Estate Records in China Need Expert Review
Strategies for Third Party and Government Interviews Are Essential
Cross-Check China Public Sources to Verify Information
Successful China Due Diligence Starts with a Clear Checklist
When kicking off the due diligence project, your team in China will prepare a checklist of all documents needed for due diligence, itemizing everything relevant to the target investment unless the client wants to limit the extent of the investigation. A targeted questionnaire to obtain written responses from the supplier should also be prepared, because this will give you a clearer view than if you relied on the list alone. Since no two investments are the same, due diligence gets the best results when the checklist is tailored to the specific transaction, and progressively updated to focus on problems identified from previous supplier responses or publicly available information that has been found.
Your plan should account for investment dynamics such as industry trends, operations, and public reputation, and the resulting data should be used to prepare follow-up questions to unearth actionable information. Your China attorneys also need to have knowledge of recent legal updates, but in reality, due diligence checklists typically follow a standard template that that becomes rapidly outdated due to unnoticed regulatory changes. Therefore, those templates need to be updated regularly, ideally whenever a relevant regulation is released. Clients of Chinese law firms need to be discerning here, because but these efforts are not immediately visible and often neglected by lawyers.
The parties should put thought into designating who will prepare the checklist and provide responses. Don’t default to dropping requests on the target company China assuming you will get an adequate response, as workers there may be confused about what they need to do. For example, early-stage startups in China often lack regular legal counsel and will hand due inquiries off to a founders, accountant, or regular employee. Lacking legal knowledge, they then send back inappropriate reply.
I addition to identifying qualitied collaborators, avoid confusion by having the due diligence checklist drafted originally in Mandarin Chinese with a high level of specificity. Provide detailed descriptions of the documents you need and make sure interview questions are thorough. Ensure that additional explanations about the meaning of certain questions is provided to ensure the recipient can clearly tell what you need.
A common mistake is to stop due diligence after initial responses and visits are completed. For a skilled investigator, more questions will come up over the course of the investigation, therefore your China attorneys should draft a supplemental list with follow-up questions and a list of additional required documents. Larger, more sophisticated target companies will need repeated supplemental checklists throughout the investigation.
Interview Executives in China to Verify the Documents are Accurate
Interview subjects should be identified in a way that can help achieve the investigation’s purposes and needs, with a focus on acquiring actionable information about business operations. Therefore, in addition to the executive team and beneficial owner, the due diligence team in China should interview department managers and any staff who have expertise and insight.
When acquiring a controlling stake in a company in China, the need for secrecy may means that you need to restrict the number of people who know about the transaction to a small number of the target company’s employees. That can frustrate the need to complete due diligence and create barriers to information across departments. After agreeing on how to communicate, consider making provisions in a due diligence plan that clearly express your mutual understanding, and implement them by structuring the deal mechanics accordingly.
Interviewing key personnel at the target company in China is necessary to fill informational gaps found in the written documentation and to cross-check documentary information. Coordinating interview schedules is important when there are third parties, such as executives, consultants, and government officials. For larger target companies that have been in business for a long time, interviews will need to be based on an extensive review of their documentation before the team will be able to do a targeted discussion of the key facts.
Once the supporting documentation has been obtained and reviewed, the due diligence team can begin conducting interviews, now that they have a general understanding of the target company and the venture, thus interviews with the management in China should be targeted to specific information.
Due diligence in China is usually rushed. A good team will process the documentation to draft their interview questions, but reality, the lawyers in China will usually rush the process, skip reading document even when provided by the target company, ask the same questions over and over or badger executives with unnecessary questions. Often, subjects will get angry with how they are being treated.
Having an advance plan does not mean it shouldn’t change as needed; your team should dynamically adjust to newly unearthed information to prepare appropriate follow-up questions. You can tell if a China due diligence team is performing inadequately by seeing if they are incorporating follow-up questions during their process.
Note that there is also no statutory requirement for private equity transactions to certify management information under signature or corporate seal. Information derived from due diligence interviews and documentations should be incorporated into the transaction documents and secured through the representation and warranties process. The China due diligence team should also review governmental documents to verify the accuracy of information of statements about registrations and filings.
At the very minimum, a private placement or acquisition necessitates reviewing the business registrar records, and real property records where appropriate.
Review China Government Filings to Avoid Surprises
The due diligence team should first look to see if digital filings can be accessed, as in recent years in China it was necessary to visit government agency offices’ record rooms. This has changed in recent years with digitized records for internal corporate and outside business record filings. In some Chinese jurisdictions, digital records are not being used, and lawyers need to make an in person visit.
You need to verify records including the most recent amendments, as Chinese business registrars have processing time between when they accept filings to publishing them, and this lag time is usually measured in days or weeks, it can take up to a year. If filings do not show the most recent amendments, you will need to verify the information through other means.
Equity pledges do not always appear in ordinary corporate records even though they are a type of corporate filing; in some jurisdictions, you must request equity pledge filings at a specific service counter or different office. Your team should make sure to ask the business registrar at the outset of an investigation what the process will be for getting complete documentation.
Real Estate Records in China Need Expert Review
If the target company for an acquisition or private placement owns buildings, you should review real property title records. Expert assistance is useful here because the real property registrars in China will not provide all information by default, instead you must file a very specific request for the information.
Making effective requests implies knowing in advance what kind of information you are looking for in real property title records, and providing complete details that will ensure the government agency provides the relevant information. Basic due diligence packages can skip these details, but a thorough due diligence investigation of a company in China should involve a verification of all these details.
But bear in mind the information format will vary by jurisdiction. For an example of how jurisdictions’ systems can differ a great deal in China, search results could appear together on one page, but in other places there is a separate report with much more granularity. If your target has multiple properties, the differences become more pronounced.
Some real property records offices provide summary table format reports for batch queries, which can save time at the expense of detail. Other records offices can produce detailed reports in response to each request, but with slower turnarounds. Large search requests in some China jurisdictions can result in delays of several weeks. Your China due diligence team should propose time management strategies, so the investigation approach best fits your needs.
Strategies for Third Party and Government Interviews Are Essential
Certain proposed investments necessitate expanding discussions beyond the target company and to third parties such as customers and suppliers, but sometimes government agencies. A fund of funds investment looking for suitable funds or fund managers, you should consider investigating the companies into which they are investing.
In contrast to IPOs in China which require interviewing key customers and suppliers, interviews for acquisitions and private placements can be done on an as-needed basis tailored to the proposed investment. A worthwhile objective is to identify major risks to the investment by verifying whether those parties are performing their contracts and analyzing the gap between their agreement and actual performance, or where one party is over-delivering.
Many acquisitions and investments are contingent on Chinese government agency opinions even for purely privately owned businesses, and in these cases, officials should be consulted during the due diligence process and before a contract has been executed. The target company is usually better positioned to identify and approach specific officials because they already have relationships with regulators, but getting these meetings in China can be unfeasible, so you may need to make a contingency plan with your counterparty if delays in getting government meetings.
Investors may want all interviews to be recorded to comply with their internal controls, but that can depend on whether the official in China is willing to cooperate, as these requirements are often unacceptable to administrative agencies. The investigation process could easily be derailed if the parties fail to agree in advance on how the interview will be conducted.
Cross-Check China Public Sources to Verify Information
A thorough search of public sources is essential due diligence for acquisitions and M&A, and should at a minimum involve using the business entity registry lookup and litigation records search. Duplicate information can be found on multiple different platforms, but some sources are not very reliable, therefore the information should be cross-checked.
For example, a government platform available in China is the National Business Credit Lookup System, and there are commercial software platforms such as Tianyancha and Qiyechacha that are more user friendly and have their own approaches for aggregating and returning information. A drawback is their data may not be current, and different platforms will display different information. The China due diligence team should therefore cross-check records between several available platforms and government records.