The Mergers & Acquisitions Litigation Review: China
M&A transactions in the People's Republic of China (PRC) have several features that shape its distinctive M&A litigation landscape. First, the majority of the companies participating in the transactions have one or several large, influential shareholders rather than a diffused ownership structure. Second, under China's company law regime, the shareholders control the power centre of a company through shareholders' meetings. The board of directors typically plays a less important role in M&A transactions. As a result, the principal–agent problem that drives litigation between shareholders and boards of directors is not the central concern here in the PRC. Instead, most disputes deal with tensions between majority shareholders and minority shareholders and between the buy side and the sell side.
Legal and regulatory background
In addition, the PRC Securities Law4 and a series of relevant regulations regulate M&A transactions involving listed companies. Transactions involving foreign investors may be subject to the PRC foreign investment law regime based on the PRC Foreign Investment Law.5 If state-owned enterprises (SOEs) are concerned in a transaction, the transaction may need to comply with relevant state-owned asset management laws and regulations, such as the PRC Law on the State-Owned Assets of Enterprises.6 Finally, the PRC Anti-Monopoly Law7 and relevant regulations may also apply should the M&A transactions involve large-scale market players and may potentially impact fair competition on the market.
In general, M&A transactions do not need approval from regulators, but the parties should update changes in their corporate structure or governance documents with the competent administration for market regulation and tax administration. Other regulators that may be implicated in a transaction include the China Securities Regulatory Commission (CSRC) or its local branches (for certain public M&A transactions), the competent state-owned assets supervision and administration commission (for certain transactions involving SOEs), the Ministry of Commerce and the National Development and Reform Commission or their local counterparts (for certain transactions involving foreign investors), and the State Administration of Foreign Exchange or its local counterparts (when transactions concern foreign exchange issues).
Pursuant to the PRC Administrative Litigation Law8 and the PRC Administrative Review Law,9 the decisions rendered by the above regulators on a specific M&A transaction may be challenged by affected parties through administrative review or administrative litigation procedures.
i Common claims and procedure
Common claims initiated by shareholders include the following.
Actions based on the company law regime
Dissenting shareholders may request the selling company to repurchase their shares at a reasonable price.10 Shareholders must bring such claim within 90 days after the general shareholders' meeting. To prevail, shareholders need to demonstrate:
- they have voted against the resolution approving the M&A transaction in the general shareholders' meeting; and
- the company has failed to reach a repurchase agreement with them within 60 days after the passing of the said shareholder resolution.
Shareholders may request the court to void the board resolution or shareholder resolution in relation to the M&A transaction.11 Shareholders must bring such claim within 60 days after the passing of said resolution. To prevail, shareholders need to demonstrate that the board resolution or shareholder resolution in relation to the M&A transaction violates laws, regulations or the buying or selling of the company's articles of association.
Shareholders may directly sue the directors and senior executives, citing that their breach of fiduciary duty in the M&A transaction has damaged shareholders' own interests.12 To prevail, shareholders need to demonstrate that:
- the directors or senior executives have breached their fiduciary duty; and
- the shareholders have suffered losses as a result of such breach.
Derivative lawsuits may be initiated by shareholders on behalf of the company, citing that the company's interests have been damaged by the breach of the fiduciary duty of the directors and senior executives or the malicious acts of the other side of the transaction, if any.13 To prevail, shareholders need to demonstrate:
- they have the qualification for initiating a derivative lawsuit – being shareholders of a limited liability company or a joint stock limited company separately or aggregately holding 1 per cent or more of the total shares of the company for 180 consecutive days or more;
- they have fulfilled the statutory requirement for attempting to solve the issue within the company by:
- requesting the company's supervisor or the board of supervisors to initiate the lawsuit, but to no avail within 30 days; or
- proving that the situation is urgent and will cause irreparable damages to the company if no lawsuit is initiated immediately; and
- the company's interests have been damaged by the breach of the fiduciary duty of the directors and senior executives or the malicious acts of the other side of the transaction.
Typically as an ancillary strategy, shareholders may exercise their right of inspection for documents related to the M&A transaction and sue the company when their requests have been refused.14 To prevail, shareholders need to demonstrate:
- the documents to be inspected fall under the scope allowed under law, for example, articles of association, board resolutions, financial reports, etc.; and
- the company has rejected, either explicitly or implicitly, their request for inspection.
Action based on the contract law regime
This action involves shareholders requesting the court to void the underlying transaction documents for the M&A transaction. According to the General Principles of the PRC Civil Law,15 to prevail, shareholders need to demonstrate that the underlying transaction document in dispute:
- does not represent a party's real intention;16
- violates mandatory laws and regulations that governs validity of civil acts;17
- violates public order or goes against social morality;18 or
- is based on malicious conspiracy that would harm a third party's legitimate interests.19
Shareholders may request the court to revoke the underlying transaction documents for the M&A transaction. To prevail, shareholders need to demonstrate that the underlying transaction document in dispute:
- is concluded as a result of significant misconception;20
- is based on the counterparty's or a third party's fraud;21
- is concluded due to the counterparty or a third party's coercion;22 or
- is obviously unfair at the time of conclusion as a result of the counterparty taking advantage of the claimant's predicament or lack of judgement.23
Depending on the specific claims raised by the dissenting shareholders, remedies may include:
- repurchase of their shares at a reasonable price;
- void the board resolution or shareholder resolution in relation to the M&A transaction;
- damages for the losses suffered by them or by the company (in the case of derivative lawsuits); and
- void or revoke the underlying transaction documents for the M&A transaction.
The PRC law does not have a statute or a developed jurisprudence recognising the business judgement rule, although some court rulings have embraced its essence when releasing directors or senior executives of a company from liabilities.
In particular, with respect to directors or senior executives of listed companies, the Measures for the Administration on Acquisition of Listed Companies stipulates that in an M&A transaction, directors of the target company shall investigate the capacity, credit status and purpose of takeover of the purchaser, analyse the conditions for tender offer, put forward suggestions on whether the shareholders should accept the tender offer, hire an independent financial consultant to issue professional opinions, submit a report of the board of directors of the target company as well as the professional opinions of the independent financial consultant to the CSRC and make the announcement.24 Accordingly, where directors can show that they have complied with the above-mentioned provision, their defence against a claim of breaching fiduciary duty is generally strong.
Directors and senior executives accused of breaching fiduciary duty also rely on the general defence that the shareholders bear the burden of proof to establish such breach and have failed to do so. This is often a more efficient strategy because PRC law provides for very limited discovery in civil and commercial litigation and it is not easy for shareholders to find strong evidence demonstrating breaches committed by directors or senior executives.
iv Advisers and third parties
In M&A transactions, independent advisers and other professional services providers such as auditors, lawyers and asset evaluation companies are usually engaged to provide professional opinions and facilitate the transaction process. These third parties should undertake a duty of diligence and may be subject to contractual or tort liability if their clients suffered losses due to their defective professional services. For instance, according to the Several Provisions on the Trial of Compensation Cases for Civil Tort Involving Accounting Firms Engaging in the Audit Business issued by the Supreme People's Court (SPC), an auditor should bear compensation liabilities for losses arising from reasonable reliance on the false audit reports issued by the auditor.25
In addition, it is not only the buyers and sellers who may be entitled to claim damages from third parties (including advisers and other professional services providers) in M&A transactions. Pursuant to the PRC Company Law, shareholders of these transaction parties who separately or aggregately hold 1 per cent or more of the total shares for 180 consecutive days or more may also initiate derivative lawsuits on behalf of the company against these third parties.26
v Class and collective actions
There is no opt-out class action mechanism for M&A litigation in the PRC. However, there are mechanisms under the PRC Civil Procedure Law27 allowing several parties to initiate a claim together or even form an open block of plaintiffs that allows future plaintiffs to opt in.28 But the opt-in mechanism has seldom been triggered in practice, primarily because there was no detailed guidance in this regard and the court would like to avoid all the complexity associated with the administration of such a proceeding. Recently, the SPC has begun to promote class actions in securities fraud cases. This latest development signals potential future expansion of use of class actions in other types of disputes, such as M&A litigations.
vi Insurance and indemnification
Directors' and officers' insurance is generally available in the PRC. For example, for listed companies, the Governance Guidelines of Listed Companies provides that a listed company may purchase liability insurance for directors upon approval by its shareholders' general meeting, excluding circumstances where the liabilities were triggered due to the directors' violations of laws and regulations or articles of association.29 However, in practice, it is not common for companies, particularly small to medium ones, to purchase insurance for directors or officers.
There are no specific PRC laws and regulations that restrict the availability of indemnities. Whether a company may indemnify its directors and officers is generally decided by the articles of association, decision of shareholder meetings or resolution of the board of directors.
PRC courts have a general tendency to encourage parties to settle disputes on their own accord or through court mediation. In practice, it is common for PRC courts to make enquiries to the parties regarding their willingness to settle and to grant the parties a period of time for negotiation of settlement.
However, caution is applied to settlement cases where shareholders have raised a derivative claim on behalf of the company in accordance with Article 151 of the PRC Company Law. Pursuant to the SPC's Minutes of the National Courts' Civil and Commercial Trial Work Conference (the SPC Minutes), reflecting the latest judicial policies preferred by the SPC, courts should place extra attention on whether a settlement agreement between the shareholder plaintiff and the defendant reflects the true intention of the company to prevent any collusion between the shareholder plaintiff and the defendant to harm the interests of the company.30 Only after the mediation agreement has been validated by a resolution issued by the shareholders' meeting or the board of directors can the courts confirm the settlement through mediation.
viii Other issues
The PRC Civil Procedure Law provides for very limited discovery in civil and commercial litigation. Parties involved in M&A litigations, especially the dissenting shareholders that do not participate in business operations will have limited access to collect and produce evidence. In practice, it is usually very difficult for dissenting shareholders to satisfy their statutory burden of proof and establish their claims against majority shareholders.
i Common claims and procedure
Common claims initiated by buyers and sellers against one another are usually contractual claims and include the following:
- A buyer or seller in an M&A transaction may seek to revoke the contract and claim damages (if losses are incurred) pursuant to the General Principles of the PRC Civil Law. Similar to shareholders' claims discussed above, in order to prevail, the claimant should demonstrate that the concerned contract is based on significant misconception, fraud or coercion, or is obviously unfair as a result of the counterparty taking advantage of the claimant's predicament or lack of judgement.31
- The most common counterparty claims are based on breach of M&A contracts including share purchase agreements and other contractual instruments based on the PRC Contract Law.32 In practice, disputes usually arise out of performance of the contractual clauses on payment, price adjustment, representations and warranties. To successfully establish a breach of contract claim, the claimant should demonstrate:
- the existence of a contract;
- the defendant's failure to perform its contractual obligation; and
- that the claimant's damages resulted from the defendant's non-performance.
- A buyer or a seller in M&A transactions may claim for pre-contractual liabilities from its counterparties if it suffered losses from the counterparties' bad-faith actions during the negotiation of the M&A contracts.33 While pre-contractual liabilities may be claimed regardless of whether the contracts exist or not, this claim is more often brought up when the M&A contracts are not formed, are revoked or are deemed void and breach of contract claims are not available for the claimant. In order to establish the pre-contractual liability, the claimant should demonstrate that:
- the defendant's bad-faith actions during negotiation, such as its intention to engage in the negotiation was not to make the transaction but to harm another party, or it intentionally concealed material facts or provided misrepresentations; and
- the claimant suffered losses therefrom.
Similar to the above discussed shareholder claims, these counterparty claims may also be brought up in derivative lawsuits, which are initiated by the shareholders of the buyers and sellers on their behalf. In terms of the timeline, general civil procedure rules will apply and the trial proceeding should usually be completed within six months. However, this is not a fixed term as it may be extended if the lawsuit involves a foreign party or if the case is deemed complicated.
The remedies available under the above typical counterparty claims are as follows:
- a claimant who claims that the conclusion of the M&A transaction is based on significant misconception, fraud, coercion or is obviously unfair as a result of the counterparty taking advantage of the claimant's predicament or lack of judgement may seek:
- revocation of the M&A transaction documents;
- restitution of the unjust enrichment; and
- compensation of losses, if any;34
- a claimant who brings up a breach of contract claim may seek:
- specific performance of its contractual obligations, including continuing to perform its obligations and taking remedial measures;
- compensation of losses, if any; or
- termination of the contracts;35 and
- a claimant who brings up a pre-contractual liability claim may seek compensation of losses arising out of the defendant's bad-faith actions.36
At the outset, a defendant in an M&A litigation enjoys the general defence that the claimant should bear the burden of proof to establish its alleged facts, as the exceptional rule of shifting the burden of proof does not apply. In practice, the defendant may also take a step further to provide evidence on their own initiative and prove that the claimant's claims are ungrounded.
Further, the defendant can make use of defence for refusing to perform a contractual obligation as provided under the PRC Contract Law, such as to request a simultaneous performance of the contract or subsequent performance after the counterparty fulfilled its obligations.
Counterparty claims are generally brought up based on contracts, which, in the context of M&A transactions, are share purchase agreements and other M&A transaction documents. Arbitration agreements or arbitration clauses are commonly used in PRC-related M&A transaction documents as arbitration is often preferred by the parties for its efficiency and privacy. In cases where the counterparty claims are brought up to claim pre-contractual liability and the underlying contracts are absent, the parties might even choose to reach an arbitration agreement so that the disputes can be submitted for arbitration.
In M&A transactions where buyers and sellers are both Chinese enterprises, the parties typically select a well-established arbitration institution in the PRC, such as the China International Economic and Trade Arbitration Commission, the Beijing Arbitration Commission or the Shanghai International Arbitration Centre. In M&A transactions where a Chinese party and a foreign corporation are involved, the Hong Kong International Arbitration Centre (HKIAC) and the Singapore International Arbitration Centre are more popular choices due to their widely-recognised reputation and mutually-accepted location. In addition, as the SPC has promulgated the Arrangement Concerning Mutual Assistance in Court-ordered Interim Measures in Aid of Arbitral Proceedings by the Courts of the Mainland and of the Hong Kong Special Administrative Region,37 PRC courts and Hong Kong courts can both grant interim measures upon application of the parties of arbitration in HKIAC and Mainland China arbitration institutions. With this easy access to interim measures including injunctions and asset preservation orders, HKIAC may become a more preferred option for M&A transaction parties in the near future.
v Other issues
China's awe-inspiring growth in the past decades brings parties participating in M&A transactions not only impressive gains but also unexpected market risks sometimes. A further compounding issue is the wide information asymmetry between the buy side and the sell side owing to the lack of a developed credit-reporting system. Consequently, investors in China prefer to embed a value adjustment mechanism (VAM) into M&A transaction documents. A VAM is a contractual arrangement between buyers and sellers or target companies to adjust the estimated value of the target company and mitigate the uncertainty of the deal associated with the potential information asymmetry and future market fluctuations. Typically, the parties may bet on certain financial performance of the target company. In the event that the target company fails to meet the goal, the seller or the target company may be required to provide monetary compensation or repurchase the shares from the buyer.
As a relatively new arrangement in M&A transactions, specific laws and regulations applicable to VAM have remained absent under PRC laws. Over a long history of judicial practice, PRC courts have relied upon general principles provided by the contract law and company law to try cases involving VAM agreements. As a result, there have been inconsistent judicial opinions on the validity, enforceability and other issues related to VAM agreements. For instance, in a case judgment rendered by the SPC in 2012 (the 2012 case), the SPC confirmed the validity of the VAM agreement entered into by the buyer and the seller of an M&A transaction, whereas the VAM agreement reached upon by the buyer and the target company was held invalid as such agreement is believed to harm the interests of the target company and its creditors.38 In 2019, however, the Jiangsu Higher People's Court decided in another case that a VAM agreement between the buyer and the target company is valid and enforceable, and further supported the buyer's request to have the target company repurchase its shares.39
Given that the VAM has become a popular arrangement in M&A transactions, relevant disputes continued to arise in which the validity and enforceability of VAM agreements have been fiercely debated in judicial practice. Unified rules were urgently needed to address such disputes. The SPC Minutes established several fundamental principles for cases involving VAM agreements. Further discussion in this regard is provided in Section VI, below.
There are certain regulatory restrictions and controls under PRC laws regarding both inbound and outbound M&A transactions. According to the PRC Foreign Investment Law, 40 foreign investment is prohibited from being made in certain fields such as domestic postal and the delivery and media industries.41 The Administrative Measures on Overseas Investment of Enterprises requires that regulatory approval shall be obtained before overseas investment could be made in sensitive fields (such as weapon development, news and media).42 In cross-border M&A transactions, the relevant parties should fulfil applicable regulatory requirements under PRC laws. Otherwise there could be uncertainty in terms of the validity of relevant contractual instruments and disputes may also arise.
Year in review
In 2019, China's economy hit its lowest level in nearly three decades owing to the impact of the escalating China–US trade war. As a side effect of the declining market, many M&A-related-disputes arose from the target company's failure to fulfil its goals of financial performance (net profits, compound annual growth rate, etc.) or share-offering under the VAM. Specifically, the acquiring companies bring suits against the target companies or their previous shareholders on the basis of breach of contract, and request them to compensate for the agreed-upon financial performance or to repurchase their shares, as may have been provided in the VAM agreements.
At this point, the SPC published the SPC Minutes, which clarify its position on several issues related to VAM and provide guidance for lower courts to follow in M&A litigations involving VAM agreements. Specifically, the SPC Minutes established the following principles:
i VAM agreements between buyers and sellers
VAM agreements reached by the buyer and the seller (shareholders of the target company) are both valid and enforceable unless a statutory ground exists that renders the agreement void (such as the agreement may harm the social and public interests; the agreement violates compulsory laws and regulations, etc.).
ii VAM agreements between buyers and the target company
A VAM agreement reached by the buyer and the target company is valid unless a statutory ground exists that renders the agreement void.
In the event that the buyer requests the target company to repurchase the shares it acquired through the M&A transaction pursuant to the VAM agreement, the VAM agreement is not enforceable unless the capital reduction process of the target company has been duly accomplished, which proves such repurchase of shares is not illegal withdrawal of shares by shareholders and would not harm the interests of the target company and its creditors.
In the event that the buyer requests the target company to provide monetary compensations pursuant to the VAM agreement, the VAM agreement is not enforceable unless the target company has maintained sufficient profit for such compensation after it fulfilled relevant statutory requirements in terms of the profit distribution, including deposit of statutory accumulation fund and deficit covering.
iii VAM agreements summary
It is widely regarded as progress that the SPC Minutes recognise the validity of VAM agreements between the buyers and the target company as compared with the 2012 case, where the interests of buyers (investors) were more protected. In the meantime, the SPC Minutes have also tried to balance the interests of the target company and its creditors by reinforcing statutory restrictions on a company's repurchase of shares and provision of monetary compensation to its shareholders. While the rules provided by the SPC Minutes have been in effect for less than a year and it remains to be seen how these rules would be applied by the courts, there is no doubt that such rules would have a profound impact on the judicial practice of M&A litigations and even future legislation in the PRC.
Outlook and conclusions
First, owing to the downturn of the economy, market uncertainty is increasing. We expect more M&A litigation may arise this year. In addition, investors in M&A transactions are more likely to drag the actual controller of the target company into the deal to provide guarantees. This may potentially lead to an increase in M&A litigation against actual controllers of target companies in the future.
Second, as mentioned above, PRC's judicial practice has already embraced the business judgement rule but has yet to form a developed jurisprudence over it. It remains to be seen whether the legislature or the SPC will shed more light on how the business judgement rule should be applied in the PRC.
1 Melody Wang is a partner, Ran Chen is a counsel and Zhongyuan Yu, Mengyi Li and Chen Lu are associates at Fangda Partners.
2 Standing Committee of the National People's Congress, PRC Company Law (2018 Amendment), effective on 26 October 2018.
3 National People's Congress, PRC Contract Law, effective on 1 October 1999.
4 Standing Committee of the National People's Congress, PRC Securities Law (2019 Amendment), effective on 1 March 2020.
5 National People's Congress, PRC Foreign Investment Law, effective on 1 January 2020.
6 Standing Committee of the National People's Congress, PRC Law on the State-Owned Assets of Enterprises, effective on 1 May 2009.
7 Standing Committee of the National People's Congress, PRC Anti-Monopoly Law, effective on 1 August 2008.
8 Standing Committee of the National People's Congress, PRC Administrative Litigation Law (2017 Amendment), effective on 1 July 2017.
9 Standing Committee of the National People's Congress, PRC Administrative Review Law (2017 Amendment), effective on 1 January 2018.
10 PRC Company Law, Articles 74(2) and 142.
11 PRC Company Law, Article 22.
12 PRC Company Law, Articles 20 and 152.
13 PRC Company Law, Article 151.
14 PRC Company Law, Articles 33 and 97.
15 National People's Congress, General Principles of the PRC Civil Law, effective on 1 October 2017.
16 General Principles of the PRC Civil Law, Article 146.
17 General Principles of the PRC Civil Law, Article 153(1).
18 General Principles of the PRC Civil Law, Article 153 (2).
19 General Principles of the PRC Civil Law, Article 154.
20 General Principles of the PRC Civil Law, Article 147.
21 General Principles of the PRC Civil Law, Articles 148–149.
22 General Principles of the PRC Civil Law, Article 150.
23 General Principles of the PRC Civil Law, Article 151.
24 CSRC, Measures for the Administration on Acquisition of Listed Companies, effective on 20 March 2020, Article 32.
25 SPC, Several Provisions on the Trial of Compensation Cases for Civil Tort Involving Accounting Firms Engaging in the Audit Business, effective on 15 June 2007, Articles 2, 4, 5 and 6.
26 PRC Company Law, Article 151(3).
27 Standing Committee of the National People's Congress, the PRC Civil Procedure Law China (2017 Amendment), effective on 1 July 2017.
28 PRC Civil Procedure Law, Articles 52, 53 and 54.
29 CSRC, Governance Guidelines of Listed Companies, effective on 30 September 2018, Article 24.
30 SPC, Minutes of the National Courts' Civil and Commercial Trial Work Conference, effective on 8 September 2019, Article 27.
31 General Principles of the PRC Civil Law, Articles 147–151.
32 PRC Contract Law, Article 107.
33 PRC Contract Law, Article 42.
34 General Principles of the PRC Civil Law, Articles 157.
35 PRC Contract Law, Articles 94 and 107.
36 PRC Contract Law, Article 42.
37 SPC, Arrangement Concerning Mutual Assistance in Court-ordered Interim Measures in Aid of Arbitral Proceedings by the Courts of the Mainland and of the Hong Kong Special Administrative Region, effective on 1 October 2019.
38 SPC, Haifu Investment Co., Ltd. of Suzhou Industrial Park vs. Gansu Non-ferrous Metal Resources Recycling Co., Ltd., Hong Kong Dia Co., Ltd., Lubo, (2012) Min Ti Zi No.11.
39 Jiangsu Higher People's Court, Jiangsu Hua Gong Business Investment Co., Ltd. vs. Yangzhou Forging Machine Co., Ltd., Pan Yunhu et al, (2019) Su Min Zai No. 62.
40 PRC Foreign Investment Law, Articles 4 and 28.
41 NDRC and MOFCOM, Special Administrative Measures on Access of Foreign Investment (Negative List) (2020), effective on 23 July 2020, No.15 and Section 12.
42 NDRC, Administrative Measures on Overseas Investment of Enterprises, effective on 1 March 2018, Article 13.