Jie Chai and Xiong Yin of Tian Yuan Law Firm review the importance and challenges of due diligence in Chinese outbound investment

In recent years, outbound investments and mergers and acquisitions undertaken by Chinese enterprises have been increasing rapidly. According to 2014 statistics issued by China's Ministry of Commerce, National Bureau of Statistics, and State Administration of Foreign Exchange, Chinese outbound direct investment (ODI) grew drastically, bringing the total amount of those transactions close to the scale of foreign direct investment (FDI) for the first time in history. A total of 595 M&A transactions were completed by Chinese companies in 2014. The total amount of ODI was $56.9 billion, of which $32.5 billion was outbound M&A. In other words, the outbound M&A transactions accounted for 57.1% of the total amount of ODI. In the 12 years since 2003, Chinese ODI has achieved continuing growth and the total ODI for 2014 was 45.6 times that for 2002.

Of all the areas of outbound M&A, mining M&A still remains the most popular, despite the effect of a depressed market for bulk commodities. However, in 2014 the total amount of outbound M&A in the mining sector declined substantially from $34.2 billion to $17.9 billion. In contrast, ODI and outbound M&A in clean energy, TMT [technology, media and communications], manufacturing, agriculture, forestry, animal husbandry and fishery achieved a rapid increase.

Since ODI and outbound M&A strides across different countries, there is more complexity and associated risk to be negotiated than in transactions conducted domestically. Chinese companies must overcome numerous problems in order to achieve success for their ODI and outbound M&A activities. First of all, Chinese companies need to invest more funds and time in due diligence investigations of their targeted entities.

Compared to the due diligence investigations carried out by foreign companies in their investment and M&A activities, the efforts made by Chinese acquiring companies on feasibility studies and due diligence investigations often appear insufficient. The budget is usually tight and the allocation of time is unreasonable for the scale of the due diligence investigations. As a result, it is difficult for the Chinese acquirers to conduct a sufficiently thorough or detailed analysis and inspection of unfamiliar target companies that are located overseas within different legal environments and commercial markets. Some Chinese mining companies, when analysing their failure in ODI projects, have cited poor decision making as a result of incomplete analysis as the most frequent cause of the downfall of their ODI projects. Consequently, it seems the risks are high and projects can be doomed even before signing the transaction agreement.

In one transaction, for example, a Chinese company through its offshore subsidiary acquired a company listed on an overseas stock exchange. Apparently, the decision makers of the acquiring company maintained a friendly relationship with the seller and thus did not conduct detailed legal due diligence. After the acquisition, however, dozens of lawsuits were filed against the target company claiming debt payments or contractual damages.

Due diligence from a purchaser's perspective is about risk control or management. In an outbound M&A transaction, a wide range of risks exists for a purchaser and its financiers to identify and manage. Those risks, for example, include the following:

  • the political risk associated with the country or countries in which the target is based;
  • the accuracy of past financial accounts of the target, for example, recent company management accounts are audited only to reveal a substantial mis-statement of earnings;
  • whether the target's key staff, suppliers and customers will remain;
  • whether the target has good title to its assets;
  • whether the assets are worth the value the target attributes to them; and,
  • whether there are any existing liabilities that may cause disruption in the future to the operations or financial performance of the target.

Due diligence investigation is a crucial part of commercial transactions such as M&A, private equity and venture capital, as well as transactions conducted in conjunction with an IPO. Legal due diligence is an efficient way of providing a basis to facilitate an informed decision regarding a planned transaction or investment. Legal due diligence also improves negotiating positions, identifies contractual and other risks regarding the planned transaction, and ensures that the parties actually get what they bargained for.

Focus of due diligence

Just as business transactions vary, the nature and scope of due diligence in a given deal will have its own characteristics and requirements. When starting a due diligence investigation, the acquirer must clearly understand what objectives it wants to achieve. Key concerns and objectives should be explained to its professional advisers.

As different industry sectors vary in their specific business requirements, there is no standard due diligence questionnaire that will apply to all target companies in different sectors, such as TMT, healthcare, energy and electric power, mining and other natural resources, trade and distribution, infrastructure, and so on. Particular consideration, therefore, should be given to the specific industry sector, regulatory environment and location of each ODI project or target company.

In TMT M&A transactions, for example, legal due diligence will often focus on intellectual property rights, such as patents, trademarks, copyrights and related rights. A review of patent portfolios concentrates on identifying the patent families of each invention, the position of the patents within the target company's research and development activities, as well as the markets and competitors of the target company. The review should establish whether the rights to inventions, patent applications and patents have been properly transferred to the company, whether the target company actually holds the necessary patents for carrying out its business, and whether the patent portfolio protects the target company's business and business prospects from its competitors. Other critical fields subject to scrutiny include trade secrets and confidential information.

Legal due diligence must also focus on the material contracts and agreements concluded by the target company. Contracts and agreements of major importance include licences. Often overlooked is the need for appropriate due diligence in the context of licensing activity. It is extremely important to review the target company's licence agreements to ascertain whether they contain any change of control provisions. Such provisions can give the counterparty the right to receive payment or even terminate the agreement where there is a change of ownership or management of the target company.

Special attention must be paid to IT processes. Frequently, when intellectual property (IP) and IT issues are addressed, the focus is on procedural matters such as the timeliness of filings and review of suit papers in pending infringement disputes, as opposed to the substance of the IP and the process by which it is developed and used.

If know-how, skills, business contacts, or trade secrets are an important part of the transaction, the due diligence team should also confirm that critical technical employees have signed confidentiality agreements and agreed in writing to assign any inventions to the target company. Extra attention to contract formalities is warranted where there has been joint development of technology or where an independent contractor contributed to technology development. The due diligence team should also ensure that procedures are in place to protect the target company's IP assets when an employee departs. If permissible, a reasonable non-compete agreement could protect against departing employees setting up shop next door or joining a competitor.

Due diligence process

Legal due diligence requires good coordination among all the parties involved in the process. It is usually conducted in close co-operation with the management of the target company, lawyers, experts and other consultants in relation to relevant special business areas, and even investment bankers to coordinate the process in large-scale transactions involving several potential purchasers.

It is important to ensure that the proper team is in place before starting the due diligence. It is imperative that the legal team undertaking the legal due diligence has a basic understanding of the primary product lines, business environment and future plans of the target. This will ensure that the team remains focused on the key components crucial to the business, such as, for example, the intellectual property assets.

Once an appropriate team has been assembled, a necessary step is to develop a well-drafted due diligence request designed to assist in identifying areas of genuine concern that are relevant to the business and the specific transaction at issue.

Multi-jurisdictional issues

An ODI or outbound M&A transaction involves investors or acquirers, financiers, sellers and target companies or assets in different jurisdictions. The transaction must be structured in a way that fulfils all applicable regulatory requirements, taking into account relevant tax planning and other considerations. The transaction usually is subject to regulatory approvals and filings in the relevant jurisdictions.

It is important to retain local lawyers licensed to practice in the jurisdiction of the target company or where the target assets or project site will be located. Local lawyers familiar with the local legal, political, cultural and business environment are essential for the transaction. Chinese companies in their ODI and outbound M&A transactions often favour a coordinated approach, where a leading firm familiar with the Chinese regulatory environment, language and culture will organise and coordinate the provision of expert advice by local lawyers in each jurisdiction involved, avoiding duplication of efforts and saving costs.


The results of a legal due diligence investigation are presented in a report for investors or other parties in the transaction. The purpose of the report is to concentrate on the major findings and possible deal breakers, which may have an impact on the contemplated transaction or investment documentation. The due diligence findings may also affect the valuations of the target company or business if the investor receives new information which may lead to an adjustment of the purchase price. Apart from considerations over the pricing, due diligence findings may dictate how a transaction is to be structured. A legal due diligence report may contain valuable recommendations for improvements or changes in certain arrangements or activities of the target company.

While ODI and outbound M&A inevitably involve important business risks and the outcome is susceptible to macroeconomic factors that are not subject to mitigation, good due diligence practice will assist Chinese companies in achieving success for their deals.


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Jie Chai
Tian Yuan Law Firm

About the author
Jie Chai (柴杰) is a senior partner in Tian Yuan's M&A practice. He received his LLB from Peking University and LLM from Tulane University School of Law (honoured with a scholarship of Tulane Law School). Jie's practice covers a wide range of outbound and inbound transactions, including cross-border M&A and financing matters. He has extensive experience in investment and development of major power, mining, natural resources, and a wide range of industries.

Recent representations include advising China Three Gorges Corporation in connection with a €3.7 billion acquisition of concession rights for Jupiá and Ilha Solteira hydropower plants in Brazil, and its €2.6 billion acquisition of equity stake in Energias de Portugal; China Huanqiu Contracting and Engineering Co on its EPC contract and related finance arrangement in connection with an oil refinery in Kurdistan, Iraq (2015 Deal of Year of China Business Law Journal); and China Nuclear Energy Industry Corporation in its international transactions.

He co-authored Country Focus: China, Getting the Deal Through: Acquisition Finance (2014), Beyond Boundaries: A Panoramic Analysis of Cross-border Mergers and Acquisitions (Jiangsu People's Publishing House, 2013), Country Focus: China, Getting the Deal Through: Licensing (2011).

Xiong Yin
Tian Yuan Law Firm

About the author
Xiong Yin (殷雄) is a senior partner at Tian Yuan Law Firm in Beijing. Before returning to China, Xiong Yin practiced law from 1994 to 1999 at the Chicago Office of Baker & McKenzie. At Baker & McKenzie, he worked for numerous foreign clients doing transactions in China and represented Chinese clients in the US. He is a member of the State Bar of Illinois, USA, and is also admitted in China.

Xiong has practiced in the areas of international investment including domestic and overseas investment, merger & acquisition, reverse takeovers and overseas listing, corporate restructuring, PE fund financing, venture exploration and mining, clean energy and natural resources, technology licensing/transfers, education, sports-related transactions and commercial arbitration.

He was awarded an LLM from Harvard Law School in 1994. When working full time at Baker & McKenzie Chicago Office, he studied at, and received a JD degree in 1998 from, the Illinois Institute of Technology Chicago-Kent College of Law. Xiong received from Peking University a Bachelor of Law degree in 1984 and a Master of Law degree in 1987. He was a PhD candidate in international law at Peking University before going to the US in 1989 to study at the University of Maryland and at Harvard Law School.