Rights defects in equity M&A
Author: Zhe Wang
Equity merger and acquisition (M&A) refers to the way that the acquirer becomes a shareholder of the target company by purchasing the equity of the target company, or subscribing its newly increased capital by agreements to participate in or control the target company. The principal purpose of M&A is to become the controlling shareholder of the target company by acquiring equity.
In accordance with article 216 of the Company Law, “controlling shareholder refers to a shareholder whose capital contribution accounts for 50% or more of the total capital of a limited liability company, a shareholder whose shares account for 50% or more of the total share of a company limited by shares, or a shareholder whose voting rights corresponding to the capital contribution or shares are sufficient to exert a material influence on the resolutions of the shareholders’ meeting or the general meeting, despite the fact that such shareholder’s capital contribution or shares account for less than 50% of the total capital or total share capital”.
With equity as the core transaction object, how to handle equity M&A prudently requires determining the legal nature of the equity, and the subject matter of the transaction.
To determine whether the equity of M&A is legitimate shall be based upon the premise that the seller has complete disposal rights to the transacted equity, namely avoiding any rights defect in the equity of the target company. If any material rights defect occurs, the capital contribution of the seller is deemed to be defective.
In consideration of these factors, a due diligence for equity shall be carried out, including the investigation of the names of shareholders involved, shareholding ratio, capital contribution means, payment time, paid-in amount, pricing basis of non-currency capital contribution, and whether there is any capital contribution dispute, transfer dispute, rights limitation, priority or nominee shareholding, etc.
In equity M&A, the buyer will, according to the equity transfer agreement, pay the purchase price to the seller to acquire the target company’s equity, so as to enjoy shareholder rights and bear its obligations. However, paying purchase price to the seller doesn’t mean the capital contribution obligation to the target company has been fully completed. Notably, equity M&A is to acquire the rights and obligations of the target company by obtaining its shareholder status.
In reality, there is always some misunderstanding that the legal responsibility in connection with capital contribution for the company may not be fulfilled, if the payment for establishing such company equivalent to or more than the original capital contribution has been paid to relevant shareholders. However, pursuant to the Company Law and article 18 of the Provisions of the Supreme People’s Court on Several Issues Concerning Application of the Company Law, Chinese judicial authorities have adopted higher standards for capital contribution obligations of buyers in M&A than that for other contracts.
If the buyer acquires equity based upon the seller’s original capital contribution, and pays the share price corresponding to such original capital contribution to the company to fulfill the capital contribution obligation, such obligation has been fulfilled. However, it’s not so ideal in reality. The buyer always pays directly the equity transfer price to the seller, in which case the buyer’s obligation for capital contribution will not be exempted after the buyer has acquired shareholder status. In the event that the buyer knows, or ought to know, the capital contribution has not been fulfilled, the buyer may bear joint and several liabilities with the seller corresponding to his/her false capital contribution.
In the event that the seller warrants and acknowledges that there is no insufficient capital contribution defect when such seller enters into the equity transfer agreement with the buyer, the buyer may deem, upon reasonable efforts, that the seller has fulfilled relevant capital contribution obligations. But because the seller actually doesn’t perform such obligation, the buyer is entitled to claim to terminate the contract due to the seller’s fraud.
If the buyer is not willing to terminate the equity transfer agreement in consideration of the company’s promising future, the competent court shall confirm the validity of the equity transfer agreement. Detailed analysis for each case shall be carried out, and whether the buyer to acquire shares has been significantly impacted by the capital contribution defects shall also be considered, so as to determine whether there is a fraud to cover the defects of capital contribution.
Even if there are any false declarations of intent, which create a reason to terminate the equity transfer agreement entered into by and between the seller and the buyer, the buyer may bear capital contribution obligations for acquiring the defected equity. According to the Rechtsschein theory of commercial law (created by German private law scholars at the beginning of the last century), the buyer may also bear insufficient capital contribution obligation. The transfer of defected equity will not be terminated based upon both parities’ mutual agreement, but often conforms to the Rechtsschein theory, such as the completion of industrial and commercial registration.
If any creditor claims that the relevant shareholder shall bear civil liability to such creditor because the shareholder fails to fulfill the sufficient capital contribution obligation to the company, the buyer may be involved in a capital contribution dispute. As a result, the buyer becomes a shareholder of the company upon the completion of changes of the articles of association, the name list of shareholders, and industrial and commercial registration upon the completion of M&A.
This series of activities has credibility with the general public. The shareholder in the industrial and commercial registration with any third party is a real shareholder according to the Rechtsschein theory, and such shareholder shall fulfill the capital contribution obligation corresponding to his/her shares. Pursuant to the Rechtsschein theory of commercial law, any legal behaviour is protected by law, and the capital contribution obligation in a defect equity transfer shall include the buyer, namely, joint and several liabilities between the buyer and the seller.
In general, the buyer shall, before M&A, pay special attention to whether the seller has fulfilled its capital contribution obligations, and investigate this via due diligence. Meanwhile, the buyer may enter into a clear agreement on equity relevant risks and liabilities with the seller, to avoid any potential legal risk.