Editor’s notes: during the Chinese New Year 2020, the coronavirus disease (COVID-19) pandemic broke out and spread at a terrific speed. On 20 January 2020, the National Health Commission of China classified pneumonia caused by the COVID-19 virus (hereafter COVID-19 pneumonia) as a category B infectious disease under the Law of the People's Republic of China on Prevention and Treatment of Infectious Diseases, and decided to take preventive and control measures of category A infectious diseases. Due to the COVID-19 pandemic, many cities in China have implemented lockdown measures and travel restrictions, delayed resumption of work, and compulsorily cancelled tourism products. Globally, it has been declared a public health emergency of international concern (PHEIC) and many countries and regions have imposed entry controls. The pandemic has not only impaired people’s lives, health, living and national economies, but also put obstacles to the negotiations, interim periods and closing of many M&A transactions involving complicated contract performance periods, volumes and timelines. Having analyzed COVID-19 impacted cases and drawing upon experience, the Investment and M&A Team of our firm has identified common risks in and proposed solutions for different transaction phases based on M&A timelines, in an attempt to facilitate the steady progress or orderly termination of M&A transactions. This article is the latter half of a two-part series and mainly analyzes potential risks posed by the COVID-19 pandemic in different phases of the M&A process and proposes solutions; for the first half please refer to A Case of M&A Transaction Severely Impacted by the COVID-19 Pandemic.

To invest in M&A transactions during the pandemic, it is advisable to identify potential risks posed by the pandemic based on each project’s timeline, and to take appropriate measures in the common interest of the parties to the transactions so as to facilitate the steady progress or orderly termination of the transactions.

1. To screen all uncompleted projects immediately

From the prospective of project management, the general timelines and steps of investment and M&A transactions include the following phases: initial consultation, due diligence, contract negotiation, closure, and integration. Before the impact of the pandemic is over, it is advisable to go through the contract, covenants, liability for breach, and other information in relation to any uncompleted project, whatever phase it is in, in order to predict what progress and steps would be affected and to at least analyze the following questions:

✓Which party/parties would be affected by the pandemic;

✓What are the rights and obligations of the affected party at the current stage of the M&A transaction;

✓What would be the possible consequences or risks if such party’s rights or obligations are affected;

✓How would the party unaffected by the pandemic respond to these consequences or risks;

What are the targeted solutions and alternative solutions to these consequences or risks?

2. Response to transactions in the consultation phase

(1) Transactions in the assessment and potential intent phase

The pandemic has caused significant distress to industries involving face-to-face interactions, such as tourism, airlines, catering, offline learning, convention and exhibition, and offline stores. Some companies may bring in zero revenue from their main business activities in the 3 months to come. In most M&A or financing transactions (excluding hostile takeovers), it is usually good news for the target companies to be acquired or invested in. For this reason, a target company will have to do its best to present itself to the future “mother-in-law” (namely potential buyers or investors), including without limitation cash flows and main business profitability. If the pandemic has a negative impact on the main business of the target company, the party being acquired can quickly organize its related businesses or other income modules or potential revenue growth to persuade investors or buyers to proceed with the investment or acquisition intent; strategies such as changing busines model (offline-to-online), cost control, and utilization of preferential government policies can also be adopted to boost the confidence of potential investors.

We have noted that a leading catering business, Haidilao, announced on 26 January 2020 on its official Weibo account that it would be closed until 31 January 2020; another announcement was made by Haidilao on the said date for an extended closedown until further notice depending on the pandemic development and government decisions. By 3 February 2020, the hundreds of Haidilao restaurants in China (the number is 550 as reported by Haidilao for the first half of 2019) have been closed for 9 days. According to Haidilao’s 2019 interim report, its revenue from the domestic market by 30 June 2019 was CNY 10.42 billion, and the total cost of employees was CNY 3,652 million. Based on these statistics, Haidilao is estimated to have lost revenue of over CNY 700 million by having a 9-day closedown①. Suppose Haidilao is a M&A target company, potential buyers would definitely re-evaluate Haidilao in consideration of the loss of profits in its main business. However, as people are confined to their homes due to the pandemic, the supply of food has become a challenge, and the demand for convenience food and fresh vegetables has increased significantly. Thus, Haidilao can rely on two associated businesses, Yihai (manufacturer of self-heating hot pot meals, instant rice and hot pot condiments) and Shuhai (provider of food supply chain services), which have seen soaring growth, to make up for its loss of business profits.

Another example is Wuhan-based Bestore Co., Ltd. (hereafter Bestore), whose IPO application was just admitted at the end of 2019. By 2 February 2020, only one fifth of its stores in Hubei have been opened, and these stores account for 40% of all of its stores. Offline business made up for 55% of Bestore’s total revenue in the first half of 2019. With the outbreak of the pandemic, Bestore has decided to shift its strategy to focus on online business, supplemented by offline operations. Arrangements are being made for offline stores to provide delivery services (especially contactless delivery) with the help of Meituan and Eleme; in addition, Bestore utilizes and mobilizes its resources of WeChat groups, accumulated over the years, to make up for the lack of offline volumes. These responsive measures taken by Bestore help to boost the confidence of investors. The person in charge of Bestore has been reported to declare that Bestore would proceed with the application and listing as scheduled.

(2) Transactions in the due diligence phase after reaching an initial agreement

Due diligence is necessary for any cautious investment or M&A transactions. For a normal domestic transaction, legal and financial due diligence usually takes one to two months. Due diligence will take longer for target companies with complicated structures or projects involving cross-border coordination. Where the entry of a cross-border team is involved, there would be greater uncertainty about the time frame depending on the judgement of the World Health Organization and the headquarters of each interested entity about the severity of the pandemic in China.

A buyer or investor would usually sign a letter of intent with the seller before performing due diligence. The letter of intent may set out an exclusivity period (during which the target company is required not to negotiate with any other potential buyers or investors so as to ensure the buyer/investor’s exclusive priority). For the sake of fairness, this exclusivity period typically spans from 3 to 6 months but can be as long as 1 year for a small number of transactions. Within such period, the investor or potential buyer needs to conduct due diligence and complete the evaluation of the target company in order to decide whether to proceed with the transaction. If the pandemic persists, the investor or buyer may not be able to effectively perform due diligence by the expiry of the exclusivity period, and an extension would need to be granted in time.

On the part of the target company, it is advisable to facilitate the transaction by taking positive actions to enable transmission of documents online. Corporate documents can be sorted according to the due diligence checklist of the investor or buyer and then transferred or made available to the due diligence team for remote review. As a matter of fact, the extent of document digitization as well as the legibility and completeness of old files of the company can be optimized to showcase the company’s soft power to the investor.

For essential matters to be reviewed independently, it is helpful to make the best use of the online access to documents provided by government agencies.

For example:

✓ Credit inquiry: according to an announcement published on Shanghai Credit Inquiry Guideline, the official WeChat account operated by Shanghai Office of the Credit Reference Center of the People's Bank of China, individuals can log on to the official website of the Credit Reference Center of the People's Bank of China (http://www.pbccrc.org.cn/) to review and download their personal credit reports after completing an identity verification; internet banking customers of China Merchants Bank and China CITIC Bank have access to their personal credit reports by logging onto the banks’ online banking services; internet banking customers of China Construction Bank, Industrial and Commercial Bank of China (note: Shanghai Branch of ICBC plans to provide online access to commercial credit reports as of 6 February 2020), and Bank of Beijing can log on the banks’ online banking services (using a USB Key) to view commercial credit reports.

✓ Inquiry of company registration records: as advised on the Company Registration Records Inquiry portal of Shanghai Municipal Administration for Market Regulation (http://scjgj.sh.gov.cn/shaic/), a company can gain access to its electronic registration records after completing an identity verification with its business license or multi-access corporate legal person certificate; inquirers from a law firm can gain access to electronic registration records of companies in the city after completing an identity verification with a multi-access legal person certificate issued to the firm by Shanghai Electronic Certificate Authority Center.

(3) Transactions in the contract negotiation phase

The pandemic has brought many transactions under negotiation into a deadlock. For one thing, contract negotiation usually starts when the investor shows interest after conducting due diligence; for another, a contract has not yet been signed and there is inevitably room for renegotiation on some rights and obligations.

The buyer needs to fully evaluate whether acquiring the target company is a strategic move, whether the prior pricing model still applies (for example, if the target company is a catering business, it may gain zero revenue from its main business in the 3 months to come), whether to reduce the purchase price, and whether to re-evaluate with further due diligence after the pandemic is over.

If financing is necessary and feasible, the target company can carry on negotiation with the following list of priorities in mind: (a) the degree of certainty of the investment; (b) how soon the investment will be received; (c) financing terms, placing as many restrictions as possible on valuation adjustment and buyback; (d) the amount financed; and (e) valuation. At this point, the target company need not attach too much importance to valuation as a ready and sufficient cash flow is a top priority.

If the target company is greatly distressed by the pandemic, it is not advisable to start financing before the business recovers and returns to normal operating levels unless there is no other option. The reason is that the two parties would take very different stances on the uncertainty. The entrepreneur would generally see it as a major accident and soon the company would resume its growth curve, whereas the investor would probably have very different opinions.

(4) Transactions for which negotiation is over and a contract is to be signed

For such projects awaiting a final push, it is advisable from the perspective of project management to sign a contract as soon as possible to set out the transaction arrangements. If execution in person is hindered by the pandemic, the parties can respectively sign a copy of the contract and exchange the signature pages by post or consider execution by electronic means. On 11 April 2019, Shanghai launched its Electronic Seal Public Service Platform (website: dzyz.sh.gov.cn) to provide services including the application for and creation, filing, inquiry, alteration, cancellation, signature, verification and usage management of electronic seals, which are legally valid and convenient.

In any case, amidst the pandemic, it is desirable to facilitate these procedures by all possible means so that transactions would not fall through due to procedural failures. Even in scenarios where it is impossible to proceed with any procedure, it is important to make all possible preparations so that matters held up by the pandemic can be dealt with immediately when the impact is over.

Efficiency is of upmost importance for concluding successful deals.

(5) Response to the loss of potential transactions

The outbreak of the pandemic coincided with the Chinese New Year, bring companies’ cash flows under greater stress. For one thing, with profits from the previous year distributed to the shareholders as dividends and to employees as year-end bonuses and performance bonuses, companies now find themselves in an awkward position when they are habitually preparing cash flows for the new year. For another, under the impact of the pandemic, most investors may not consider projects in large quantities until March (the management of investors would be cautious against the chance and consequences of their employees catching COVID-19 on business trips and, in terms of etiquette, investment managers would not like to have face-to-face communication with entrepreneurs while wearing a mask), so target companies in need of investment have to brace themselves for at least 1 to 2 seasons of delay in obtaining financing.

It is likely that many target companies in need of investment will be exposed to distressed or even ruptured capital chains after potential investors back out. Target companies in this situation, especially medium, small or micro businesses, may consider debt financing by the following means:

✓ To apply to a bank for a loan or loan extension. The Notice of Further Strengthening Financial Support for the Prevention and Control of the COVID-19 Pandemic (YF [2020] No. 29), issued by People's Bank of China, Ministry of Finance, China Banking and Insurance Regulatory Commission, China Securities Regulatory Commission, and State Administration of Foreign Exchange, provides as follows: for industries significantly affected by the pandemic such as wholesale and retail, accommodation and catering, logistics and transportation, and culture and tourism, and for businesses with prospects but temporarily in difficulty due to the pandemic, especially small and micro businesses, financial institutions shall not blindly demand early repayment of or delay or cut off loans. Companies which are affected severely by the pandemic and have difficulty in making repayments when due may be granted an extension or renewal. Government financing re-guarantee institutions at all levels shall cancel counter-guarantee requirements and reduce guarantee and re-guarantee fees. In compliance with the Ten Policy Opinions of the People's Government of Suzhou Municipality on Responding to the COVID-19 Pandemic and Supporting Small and Medium Companies through Difficulties (SF [2020] No. 15), Suzhou has reduced lending interest rates by over 10% for small and medium companies in key sectors with financial difficulties, making sure that the financing costs incurred by small and micro businesses in 2020 would not be higher than those in the same period in 2019. The Opinions also urge Bank of Suzhou and Suzhou Rural Commercial Bank to grant loans for special projects and reduce interest rates, making sure that lending interest rates would be lower than the loan prime rate for the same period; for companies listed as key companies by the Ministry of Industry and Information Technology and other competent authorities, a further reduction of over 30% will be granted.

✓ To consult with existing shareholders for assistance and consider obtaining bridge loans by means of shareholder loans, equity/debt swaps, and convertible bonds. The latter may be more effective than the former, as existing shareholders are in the same boat with the target companies: they share common interest with and have a deeper understanding of the target companies, and are likely to be motivated to help the target companies survive the winter amidst a raging pandemic.

✓ To use financial tools such as accounts receivable pledging, accounts receivable factoring, and notes receivable factoring to shorten collection periods and obtain cash flows faster.

3. Response to transactions in the interim period

(1) Sellers’ representations and warranties, and changes to and notices of covenants

In investment and M&A transactions, the buyer will usually request the seller and/or target company to make representations and warranties about the status quo of the company on the date of signature of the contact, so as to ensure that the information obtained by the buyer in the due diligence process is true, complete and accurate without any concealment or omission. When it is difficult to conduct full due diligence, the transaction may even proceed relying on the representations and warranties made by the seller and target company. In this case, the representations and warranties clause should be more exhaustive. Normally, representations and warranties made by the seller and target company would at least include statements about no third-party incumbrances (other than those disclosed) on or any foreseeable dispute in relation to the target assets/equity. As the year is drawing to an end and under the impact of the pandemic, many target companies are faced with tight cash flows while banks are under the pressure to collect debts. If a target company fails to get an extension from the bank or any other creditor, foreseeable disputes may arise. In this case, the party making relevant representations and warranties needs to promptly notify the other party, to check whether the representations and warranties clause is to its own disadvantage and to eliminate any such disadvantage in advance.

Covenants in a M&A transaction are typically promises made by the seller or target company to fulfil certain obligations after the execution of the contract, in order to resolve problems or flaws identified by the buyer or investor in the due diligence process. For example, in an asset acquisition that involves making changes to the registration of special chemical equipment, if the original documents accompanying the equipment when it was initially installed are long lost, the seller’s assistance would be needed to urge the initial installer to issue a certificate and sign the application for changes. If the seller’s communication with the installer is frustrated, hindering the changes to the registration, not only would the deal closing be postponed, but the seller would also incur actual loss due to restrictions on its subsequent operations. In this case, the buyer needs to follow up closely with the seller lest the seller should put off offering such assistance using the impact of the pandemic as an excuse. To give another example, in the M&A transaction uncompleted under the impact of the pandemic as mentioned in A Case of M&A Transaction Severely Impacted by the COVID-19 Pandemic, Company A is obligated to urge the target company to obtain an extension of its core licenses by the end of January 2020. This is a covenant made by Company A. However, if Company A postpones applying for the extension, claiming force majeure on the grounds that competent authorities in Wuhan are closed after 23 January, the buyer, Company B, may reject the claim as Company A should be able to foresee the approach of the Chinese New Year holidays beginning from 24 January. It should complete the application by 23 January and should not leave it to the end of January.

(2) Interim period arrangements, and adjustments to payment terms

The interim period of an M&A transaction is the time between the execution of the contract and the closing of the deal. The longer the interim period, the higher the risk for the buyer. For this reason, in a large transaction with a long interim period, the buyer would usually dispatch representatives to the premises of the target company to attend meetings, participate in decision-making, and jointly and physically manage the company seal, certificates, licenses, and USB Keys. However, with the outbreak of the pandemic, it becomes impracticable to conduct such joint management if the target company is located in Hubei. Without the joint management, the target company may still need to continue with its operations and production, giving rise to a series of uncertainties as to the division of rights and obligations and the sharing of risks. To cope with this, the parties to the transaction are advised to enter into a supplementary agreement as soon as possible to make adjustments to the interim period arrangements and follow-ups.

In an acquisition, the performance of the seller’s and target company’s covenants and certain actions in the interim period is typically a precondition for the buyer’s payment of instalments. For example, in a share acquisition, the change of industrial and commercial registration is a precondition for the payment. If such change is hindered by the pandemic, adjustments should be made to the precondition for the payment. For instance, in the affected transaction mentioned in A Case of M&A Transaction Severely Impacted by the COVID-19 Pandemic, Company A’s failure to obtain an extension of core licenses that will soon expire may affect the payment of a subsequent instalment. It is then necessary to assess whether the precondition for the payment should be adjusted.

(3) Adjustment to and apportionment of gains and losses in the interim period

Transactions under the impact of force majeure usually involve losses. Compared to straightforward sales contracts and service contracts, M&A transactions are more complicated and often involve more than two subjects of rights and obligations. Their interests are intertwined: a matter may be conducted by one party or jointly by two or more parties; some acts depend on another party’s performance, and some acts are carried out by more than one party at the same time. Thus, when a party to a M&A transaction is under the impact of force majeure, the impact will be more likely on the timeline of the transaction or some conditions for the performance. Besides, the impact of the pandemic may be short-term for a M&A transaction and is therefore not sufficient to overturn the whole deal. This is why during the SARS outbreak in 2003, disputes did not erupt with force majeure claims in M&A transactions or public company restructuring transactions.

Speaking from experience, the buyer in a M&A transaction may set some limits on gains apportionment and the amounts of expenditures and make certain arrangements for the assumption of losses of the target company during the interim period. This is to ensure that the value of the target company upon closing does not differ too much from that in due diligence. For instance, an investment agreement may provide that the target company shall obtain the buyer’s prior consent if any of its expenditures exceeds a certain amount, and shall not offer a large pay rise or an excessive severance pay to its employees and officers without the buyer’s consent.

Essentially, the said joint management and on-site participation in decision-making by representatives in the interim period are also measures taken to ensure the target company continues with its normal operations in the interim period and reduces dishonest or even hostile acts that affect its business revenues and debts. If such arrangements cannot be made in the interim period, alternative solutions could be setting out minimum gains and maximum expenditures. Where the minimum gains are not reached or the maximum expenditures exceeded, prejudicing the buyer’s interest, adjustments may be made to the purchase price or compensation may be claimed by the seller.

4. Response to transactions in the post-closing phase

After the closing of a transaction amidst the pandemic, in addition to common challenges of business and employees integration and daily operations of the target company, the focus of a M&A transaction may be on the target company’s performance as regards valuation adjustment and on finding solutions in case such performance fails the criteria.

The Notice by the Supreme People's Court of Issuing the Minutes of the National Courts' Civil and Commercial Trial Work Conference (F [2019] No.254, commonly referred to as the Ninth Civil Meeting Minutes) provides that people’s courts, when trying “valuation adjustment mechanism (VAM) agreement” dispute cases, shall apply not only relevant provisions of the Contract Law but also relevant provisions of the Company Law; and shall adhere to the principle of encouraging investors to invest in physical enterprises, especially technological innovation enterprises, so as to ease enterprises’ difficulty in  financing to a certain extent. Courts are also required to implement the principle of capital maintenance and protect the lawful rights and interests of creditors so as to duly balance the interests of investors, companies’ creditors, and companies. In view of the importance attached by the judicial authorities to the balance of the three interests in the trial of VAM disputes, target companies need to make more efforts to gather and sort evidence if they are affected by the pandemic and plan to seek to ease or be excused from their VAM obligations by claiming force majeure.

Even if the pandemic constitutes force majeure and even if target companies are able to make force majeure claims in relation to the impact of the pandemic on their operations, it is very difficult to prove that the failure in their VAM performance is directly caused by the pandemic. After all, (1) the pandemic will not persist for a long time and has only a limited impact; and (2) the performance requirements under VAM would be paired with a reasonably long period of time typically measured in a year or even years. In such circumstances, target companies will have to give accounts of the extent of material impact of the pandemic on their business, whether they have conducted any other act during the VAM period that may affect their performance, and whether they have taken reasonable measures to sustain their performance.

In conclusion, for target companies anticipating a failure to meet the VAM performance indicator due to the impact of the pandemic, a feasible suggestion would be to consult with the investors in advance and come up with solutions, such as extending the VAM performance period and changing the methods of valuation adjustment (for example, changing from valuation adjustment in cash to milder methods such as free transfer of shares by the original shareholders).

You only find out who is swimming naked when the tide goes out. This article is dedicated to uncompleted M&A projects affected by the pandemic and all interested parties who work very hard to carry on these projects. The spring will come, and we hope everyone is staying healthy and safe!

[Special thanks are given to Wen Congjun, director of M&A and Restructuring Business Research Committee of Shanghai Bar Association, and Chu Xiaoqing, deputy director, for their guidance and assistance with amendment throughout the writing of this series of articles.]

① For information about Haidilao, please refer to the article Behind Haidilao’s Resolute Decision to Close Down amidst the Pandemic published on Huxiu App on 3 February 2020.

Wang Xiaoli

Senior partner of Shanghai Yingdong Law Firm

Leader of Investment and M&A Team

Ni Chenliu

Lawyer of Shanghai Yingdong Law Firm