By Nie Shengnan, DeBund Law Offices

Due diligence is an important job of non-litigation lawyers. In most M&A cases, clients take further action according to results of due diligence by their lawyers and accountants. Due diligence on businesses in different industries have different focuses, based on the complexity of the industry under investigation. This article is intended to introduce important elements of due diligence in M&A cases based on our experience in due diligence on real estate businesses. (Transactions mentioned in this article are equity M&A transactions, not assets M&A transactions)  

1.Documents showing qualifications of the target company, including

a."one approval and two permits" mean building land use approval, building land planning permit and building project planning permit

b.state-owned land use right certificate

c.state-owned land transfer agreements and relocation compensation agreements

d.documents required by the National Development and Reform Commission or approval for the feasibility plan

e.construction permit

f.presale permit

g.house ownership permit

h.plan review opinions or approval by the planning authority for the plan

i.approval for additions to the initial design of the project

j.opinions of municipal departments on the project

k.descriptions of the plan and additions to the initial design or construction drawings

l.geological exploration report

m.check and acceptance reports

n.area survey materials

o.approval documents for construction of environment, fire, sanitary and other facilities

Property projects involve a lot of regulatory approvals and local policies. Lawyers should advise project providers gradually provide necessary documents in different stages of the M&A project including documents necessary for filing and construction of the project, in order to decide if land is lawfully acquired for the project and if there are major risks such as ones from vacant land and check the approved uses of the land and the completeness, legality, etc. of documents and formalities necessary for obtaining approval from relevant government departments in different stages of the M&A project.

2.Legal risks facing the project company during the performance of agreements

Main agreements made by property developers include

a. land transfer agreement

b. construction engineering and design agreement

c. landscape design and construction agreement

d. exploration and survey agreement

e. building project construction and contracting agreement

f. labor contracting agreement

g. supervision agreement

h. purchase agreement

i. amenities agreement (water, electricity or gas supply, pipelines, communication)

j. property agreement

k. marketing plan agreement

l. house presale agreement

In addition to the content of each of these agreements, lawyers should check information about the performance of each of these agreements, including information about change in the performance of the agreement and the amounts paid and owed, and keep financial records to evaluate legal risks and economic responsibility during the performance of the agreement. For example, when performing a design or construction agreement, the target company should strictly comply with the tendering and bidding rules to appoint contractors, subcontractors, suppliers and other parties, choose a surveyor and a designer, both of whom have necessary qualifications, avoid risks from contractor violation of laws, quality and safety of the project, black and white contracts, etc., complete all processes of acceptance of the project as set forth in the agreement, specify the warranty period and pay the project price and workers’ wages in a timely manner to avoid disputes; when performing a sale or planning agreement, the target company should not include anything false or wrong in its advertisements, delay the property ownership transfer or registration or shirk its responsibility for default, and ensure the amounts received from the property buyer accord with relevant bank statements. Another thing that should be considered is that whether the property transfer is delayed is based on whether conditions for closing the property transaction are fully met. In addition to meeting the mutually agreed conditions, obtaining registration and approval documents is required for closing the transaction. Without these documents the transaction would not be allowed to close even if keys are given to the property owner. Details that people tend to neglect sometimes just become potential risks.

3.Liabilities of the target company

Information about liabilities of the target company can be obtained from existing financial records and auditing reports with agreements, invoices, credit notes, etc. being taken account. Checking if there are liabilities or non-disclosure obligations is an important job of lawyers performing due diligence.

Relevant materials that need reviewing include:

a.financial records such as general ledger, accounts details, cash journal and cost ledger

b.details of borrowing from banks and non-financial institutions

c.details of assurance and guarantee to external parties

Due diligence on a company with liabilities usually involves reviewing agreements, interviewing senior and other members of management and searching information open to the public. A company is like a small community where disagreement is unavoidable. The more people interviewed, the more valuable information obtained. Further study of this information could help to get more findings.

In addition, as they have to execute various kinds of agreements involving large amounts of money, real estate businesses should give close attention to invoices and tax risks concerned. Lawyers should carefully check if invoices issued by important accounts comply with applicable laws and rules and if parties to the construction agreement, construction permit, invoices on the amounts received and bank statements are consistent, in order to avoid risks of the target company failing to make deductions from land value added tax and enterprise income tax after merger and acquisition.

4.Local Policies

Here is an example case. In a due diligence we conducted on a real estate business in Kunshan, we found out that the company obtained all necessary approval documents such as construction permit without approval of the National Development and Reform Commission. We went to relevant government department for further information, getting to know that it was a special case that happened for historical reasons. Later the company managed to obtain the approval of the National Development and Reform Commission, making its M&A transaction safer.

According to Chinese tax laws, in a share transfer transaction, if there is no premium in the share transfer price (fixed based on fair value), no individual income tax is payable by the transferor if he or she is a natural person and no enterprise income tax is payable by the transferor if it is a legal entity. However, a tax authority in northern Jiangsu requires that share transferors should pay enterprise income tax or individual income tax (with average tax rates between 1‰ and 3%, calculated in complicated ways) regardless of transaction prices, and states that failure to pay the taxes will result in refusal of AIC departments to approve change registration. This requirement apparently conflicts with higher-level laws, but our client who wanted to accelerate the progress of the M&A transaction had to pay the tax.

5.Related Transactions

Related transactions should be investigated in the process of due diligence. Checking if these transactions are real is important because many companies do business with other companies under their direct control in order to increase or reduce costs for different purposes. Related transactions may cause others to form wrong opinions on the target company in M&A transactions. As it is very difficult to get information about related transactions, lawyers need to do much more than consulting AIC registered information about suppliers and accounts of the target company, in order to find and investigate related transactions and evaluate legal risks involved.