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2021

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07

Lawyer Wu Jie: How Lawyers Conduct Legal Due Diligence in Enterprise Merger and Acquisition Transactions (5)

In mergers and acquisitions, equity mergers and acquisitions have become the most common trading method in the market, considering factors such as transaction purpose, transaction mode, and tax burden cost. In equity merger and acquisition transactions, the equity structure and equity burden of the target company are issues that must be focused on and verified in due diligence.


In mergers and acquisitions, equity mergers and acquisitions have become the most common trading method in the market, considering factors such as transaction purpose, transaction mode, and tax burden cost. In equity merger and acquisition transactions, the equity structure and equity burden of the target company are issues that must be focused on and verified in due diligence.

 

Equity structure and equity burden

 

1. Equity structure

 

(1) Verification methods and documents

The clarity and stability of the equity structure are the top priorities that need to be verified in enterprise mergers and acquisitions, especially in equity acquisition projects. The verification methods for this section mainly include document review, online verification, and interviews. In the case of entrusted shareholding (equity proxy holding), it is crucial to confirm the interview with the company's shareholders. The main verification documents include industrial and commercial documents, company articles of association, shareholder agreement, shareholder register, capital verification report, entrusted shareholding agreement (equity holding agreement), etc.

 

(2) Legal issues to pay attention to

In verifying the equity structure of the target company, the most common situation that affects the clarity and stability of the equity structure is equity proxy holding. Taking a certain project handled by the author as an example, let's briefly discuss the legal issues related to equity holding in mergers and acquisitions projects.

In a real estate acquisition project, the acquiring party intends to adopt a transaction mode of acquiring all or part of the equity to achieve the real estate development of a certain plot of land. We have reviewed the business records of the target company and conducted inquiries through websites such as the National Enterprise Credit Information Publicity System. It is shown that the shareholder of the target company is natural person A, who holds 100% of the target company's equity. During on-site due diligence, we reviewed the financial statements and audit reports of the target company and found that there were significant other payables in the target company's financial statements for the past two years, but there were no corresponding contract documents for these payables. In the interview with shareholder A of the company, shareholder A stated that they are not the actual investors of the target company, and the actual investors are natural persons B and C, while the other payables in the financial statements are mainly shareholder transactions and shareholder loans. Through interviews with natural person shareholders B and C, as well as further verification of the relevant written documents provided by the target company regarding equity proxy holding, we have learned that a three-layer proxy holding relationship has been formed between the target company's shareholders through project acquisitions, loan guarantees, and other forms. More importantly, the written agreements on proxy holding among shareholders are incomplete and contradictory, and the statements on equity proxy holding and shareholding ratio among shareholders are also inconsistent.

 

After verification, we believe that there is a situation where the target company's equity is held by multiple agents. If a nominal shareholder transfers a portion of their equity to a third party or sets a pledge or other third-party rights burden on it, the actual shareholder's equity may face risks, resulting in potential disputes over the target company's equity. In addition, due to the lack of written legal documents regarding the exercise of shareholder rights such as disposal rights, voting rights, decision-making rights on major matters, and decision-making rights of senior executives between actual shareholders and proxy shareholders, there may be potential disputes between actual shareholders and registered shareholders regarding the aforementioned matters.

 

In the end, the acquiring party adopted our suggestion, believing that the risks in the target company's equity structure were uncontrollable, and ultimately decided to abandon the project.

 

2. Equity burden

 

(1) Verification methods and documents

(1) Verification methods and documents

 

(2) Legal issues to pay attention to

The most common equity burden is equity pledge and equity freeze.

 

a. Equity pledge

In another merger and acquisition project handled by the author, after online verification, we found that 60% of the target company's equity had been pledged. After checking the "Equity Pledge Agreement" provided by the target company, we learned that shareholder A of the target company pledged 60% of its equity as collateral to the pledgee, and the equity pledge has been registered. We believe that 60% of the target company's equity has been pledged externally. According to Article 443 of the Civil Code, the transfer of such equity must obtain the consent of the pledgee, otherwise there will be legal obstacles and it will be impossible to apply for industrial and commercial change registration. The price obtained from the transfer of such equity shall be paid in advance to the pledgee or deposited. In addition, if the debtor fails to fulfill the due debt or if the parties agree to exercise the pledge, the pledgee has the right to exercise the pledge, and the equity may face the risk of being disposed of by auction, sale, discount, or other means.

 

b. Equity freeze

In the same project, apart from equity pledge, we found through online inquiries that a portion of the target company's equity was frozen by the court. After interviews, we learned that the equity freeze was carried out by the actual shareholders of the company through pre litigation property preservation measures, in order to ensure the safety of transactions during the project development process. In this regard, we believe that when the equity of the target company is frozen by the people's court, the distribution of dividends and bonuses to shareholders will be restricted, and the transfer of equity will also be restricted. According to Article 53 of the "Provisions of the Supreme People's Court on Several Issues Concerning the Execution of Work by People's Courts (Trial)", frozen equity shall not go through investment income or equity transfer procedures, shall not pay dividends or bonuses to the person subjected to execution, and shall not transfer equity on their own. In addition, there is a risk of such equity being transferred by the people's court through auction, sale, or other means.