U.S. and European companies continue to receive bids to sell themselves and their significant assets to companies based in the People’s Republic of China. Evaluation of these proposals requires due diligence of the acquiror’s ownership structure, assets, cash position, and financing sources. Moreover, even if this due diligence exercise gives rise to satisfactory results, the continued unpredictability of the PRC government (including its recently enhanced foreign exchange control measures), coupled with the ties of some of these buyers and financing sources to governmental entities in the PRC, as well as the challenges that a non-PRC counterparty faces when seeking to enforce contractual obligations and non-PRC judgments in PRC courts, merit the implementation of an array of innovative provisions in M&A Agreements to protect the seller/target. Several months ago, we reviewed these provisions in a popular post. This new post updates that earlier post to reflect recent regulatory developments and the evolution of market practice.
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 employ a form of credit support for the reverse break-up fee obligation. These credit support mechanics include payment by the acquiror of a deposit to the seller/target or into an escrow account or the delivery by the acquiror of a letter of credit or bank guaranty. Here are some observations about the workings of these reverse break-up fee structures, and the related security arrangements, in acquisitions by PRC entities:
- Magnitude of the reverse break-up fee. Recent reverse break-up fees accepted by PRC buyers have ranged in magnitude from approximately 3% to as high as 15% of the enterprise value of the transaction.
- Timing of security for the reverse break-up fee. The required timing for having the credit support mechanic in place to secure the payment of the reverse break-up fee ranges from having the full amount of the deposit or other form of credit support in place concurrently with the signing of the M&A agreement, which can present challenges given the internal and Chinese regulatory processes required for PRC entities to obtain hard currency, to phasing in the security arrangements over periods that extend, in some cases, up to several months after the initial signing and announcement of the execution of the M&A agreement. In some cases, the phasing in of the security arrangements is tied to the occurrence of a specific transaction-related event (e.g., shortly in advance of the target’s shareholder vote, upon an election to extend the drop-dead date to continue to pursue a particular regulatory approval or upon receipt of target shareholder approval). In view of the risks associated with the rapidly changing foreign exchange control regime, it has become increasingly standard to require that at least a meaningful portion of the deposit or other credit support arrangement be in place at the time the definitive acquisition agreement is signed.
- Magnitude of the security arrangements relative to the reverse break-up fee. The security arrangement will typically cover 100% of the amount of the highest possible reverse break-up fee specified in the agreement, although there are exceptions in deals involving tiered reverse break-up fees.
- Currency and jurisdiction of security arrangements. Escrow deposits securing reverse break-up fees are almost always in a Western currency and usually with a Western banking institution or the branch of a PRC bank located in the jurisdiction of the target, although sellers and targets are increasingly permitting portions of the deposits to be in renminbi (based on fixed foreign exchange ratios) and/or in banks in the mainland PRC. We expect, however, that the acceptance of credit support from PRC branches of PRC banks will become more rare in view of the risks arising from recently enhanced foreign exchange controls.
- Triggers for payment of the reverse break-up fee. 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 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 authorities are indirectly “affiliated”, or otherwise have good relationships, 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, SAFE); 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. In addition, it is especially important for targets and sellers to be expansive in the scope of PRC governmental impediments that trigger the reverse break-up fee and, in particular, to cover currency conversion and cash transmission impediments. It is not uncommon for all PRC regulatory approvals for the combination of the businesses in question to be in hand, but for the sign off of SAFE to remain outstanding – not for the consummation of the acquisition per se but solely for the conversion of the PRC buyer’s renminbi into foreign currency funds and the transmission of foreign currency funds out of the PRC.
Payment of the purchase price at closing. In view of the difficulties and risks relating to securing PRC buyers’ reverse break-up fee obligations, sellers and targets have been shifting their focus from reliance on the threat of a reverse break-up fee payment as a lever to assure payment of the entire purchase price at closing, to other mechanisms to assure payment of the entire purchase price at closing. One recent U.S. public company target required the acquiror to deposit the aggregate merger consideration three business days before the target’s shareholders meeting to approve the transaction. And a small-cap U.S. public company target required the acquiror to deposit into escrow at signing the full amount that would be payable to the unaffiliated stockholders at closing. In other transactions, the parties have included specific covenants to assure that necessary steps were taken, such as incurring U.S. dollar debt outside the PRC, in the event that cash resources located within the PRC were unavailable for payment of the purchase price at closing due to currency conversion delays. However, reliance on the availability of U.S. dollar loans from PRC banks has become more challenging in recent months due to enhanced scrutiny by the PRC regulatory regime of the use of PRC assets to secure such loans.
Ability to enforce obligations. Although it is generally advisable for targets and sellers to include at least a reverse break-up fee structure backed by a form of reliable credit support, targets and sellers will typically include more traditional enforcement mechanics in tandem with a secured reverse break-up fee structure. Although the enforcement by PRC courts of judgments by U.S. state and federal courts can be challenging and uncertain given the absence of a judicial treaty between the two countries, there are relatively reliable precedents for the enforcement by PRC courts of international arbitration awards obtained in accordance with the New York Convention. Arbitration provisions, however, 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 (including, more recently, Delaware’s newly adopted rapid arbitration proceedings). However, this approach may give rise to complications, since many disputes involve claims for both equitable relief and damages, and, in any event, the 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.
For now, as manifested by the chart at the link below, practice on all these points still varies.
To view the updated chart providing a brief overview of the terms of selected recent M&A transactions involving PRC acquirors, click here.