Avoiding Pitfalls in International M&A

1. What is this article about?

Nowadays it is the rule rather than the exception that M&A transactions involve more than one jurisdiction. Subsidiaries, branches and business divisions are spread all over the world, management and supervisory functions, research and development capabilities, manufacturing and sales activities span over several countries. One could stop here and state that this meanwhile simply became a matter of course. Surprisingly, however, it is still reality that principals and deal advisors concentrate too much on their own (and therefore known) legal and business environment.

It certainly makes sense to focus on the key jurisdictions where the lion share of a business’ value is generated (eg when allocating costly due diligence resources). Nonetheless, the point in time will come in every cross-border deal where at least a minimum tribute must be paid to the peculiarities of each jurisdiction involved. Ignoring these may lead to unpleasant surprises. And believe me, it happens: Local legal specifics have demonstrated the ability to impact the timing, the structuring or even the feasibility of international deals.

The lesson learned from fifteen years doing international deals is: To successfully run international projects you must abandon the known legal terminology, remain curious and dare to stay off the beaten tracks and, finally, you should keep asking questions until you fully grasp the legal concepts your foreign counterpart is explaining you. This international M&A mindset will help avoiding the traps of miscommunication, misunderstandings or, even worse, (hidden) disaccords.

2. Shareholding requirements

2.1 Number and structure of shareholders

Many jurisdictions provide for certain rules and limitations for holding shares in local legal entities. To name examples, a THAI limited company must have at least three shareholders, a COLOMBIAN limited company at least five. Other jurisdictions, such as POLAND and the CZECH REPUBLIC, may provide for specific chaining rules. These provide that there must not be a chain of entities having only one shareholder and/or that the number of shareholders of a unipersonal entity must at least be two.

Multiple shareholder requirements must be considered when designing an acquisition structure. The minority shares required to achieve the minimum number of shareholders are often held either by other entities belonging to the same group (as a corporate shareholder if permissible) or by members of local or international management (which of course increases the dependency on the management). Full economic ownership, which may be required for tax purposes, can be achieved by entering into nominee or trust agreements between the main and the minority (nominee) shareholder(s).

2.2 Nationality or residency requirements for shareholders

Requirements related to the nationality of shareholders may even cause worse headaches. Some countries have foreign investment rules reserving certain commercial activities for their nationals, or at least limiting the participation of foreign shareholders in entities engaging in such businesses (the more common way to restrict and/or control foreign investment is certainly via statutory approval requirements, see no. 6 below).

In INDONESIA and SAUDI ARABIA certain business fields are closed or restricted for foreign investment, all shareholders (or a certain percentage - depending on the field of investment) must be nationals (legal entities or individuals). In the UNITED ARAB EMIRATES, a national or a company wholly owned by a national must hold at least 51% of the shares in any legal entity irrespective of its business (exceptions apply to a very limited type of legal entities). In THAILAND retail and service businesses may only be conducted by foreigners holding a licence from the competent governmental authority. In fact, THAILAND is a good example how nationality requirements can complicate things: Certain exemptions apply via international treaties with countries such as the U.S. and JAPAN. Where a THAI business subject to such a requirement is conducted through a group of companies, it is not enough for the ultimate shareholder to fall within an exemption. Rather, this must be the case for each entity that is part of the corporate chain from the ultimate shareholder down to the THAI entity. Any breach of these rules may constitute a criminal offence empowering local authorities to close operations conducted without proper licence. Finally, in some sectors foreigners may not obtain licences at all or only under exceptional circumstances. Unsurprisingly there are similar restrictions in the PRC where foreign investors are prohibited to do investments in certain industry sectors as set forth in a catalogue published by the government.

Under BRAZILIAN law, all foreign shareholders (whether legal entities or individuals) must be resident in Brazil with powers to receive service of process on its behalf.

3. Stamp and (share) transfer duty, real estate transfer tax

Share transfers may be subject to a transfer or stamp duty. Sometimes this is just a nominal fee. Yet, it can also be a major amount to be determined in accordance with the value of the shares. This is the case eg in the UK, PRC and MALAYSIA. Where a stamp duty is payable, the validity of the transfer may depend on completion of the stamp duty assessment and payment process (eg in the UK). Prior to payment of the tax, the new shareholder may be unable to exercise its shareholder rights and may not be registered as the new shareholder. To bridge the time gap, the old shareholder may issue a power of attorney to the new shareholder.

Where an entity owns real estate, the transfer of such entity’s shares may trigger real estate transfer tax. GERMANY for example follows this system (thumb rule: if at least or more than 95% of the shares are transferred, real estate transfer tax is triggered). Interestingly, this German tax is levied at the signing of a transaction (even if eg merger control clearance is still pending). The good news is that - should the transaction, for whatever reason, not be closed - the amounts paid will be reimbursed. Yet, this is a key watch-point as it may require thorough liquidity planning even before closing for transactions involving sizeable real estate portfolios. To avoid this type of transaction costs, transfers are often structured in a way that the shares of the operating business remain untouched and the transfer occurs on a higher corporate level. Still, tax counsel will have to advise whether such a structure is acceptable does in fact avoid the transfer tax.

4. Requirements for foreign managing directors and their liability

Following completion, the acquiror may want to exchange local management. Typically, international groups appoint top management members as managing directors of their international subsidiaries. Note that some jurisdictions still provide residency, language, visa or other requirements a local managing director must meet to be eligible for such a position. Local legislators are indeed creative when it comes to defining the residence criteria for managing directors of limited liability companies: ARGENTINA: the majority (per headcount) of the managing directors must reside in the country; BRAZIL: all managing directors must do so; CHILE: the CEO only must live in Chile; FINLAND: at least one ordinary member of the board shall be resident within the European Economic Area; GERMANY: no residency prerequisites as long as the appointed individuals may easily access German territory or timely obtain visa; SWITZERLAND: At least one director or officer with single signatory power or two directors or officers with joint signatory power by two have to be Swiss-residents.

Also, newly appointed managing directors often must be registered with local authorities and in this context disclose certain personal information such as date of birth or residency status. Note that, to be registered in GERMANY, a newly appointed managing director must sign an application to the commercial register in person in front of a notary (and if this occurs abroad, also an apostille will be required).

Representatives of foreign acquirers are occasionally (and in particular with a view to potential personal liability exposure) reluctant to act as director of international group entities. Directors or managers of local companies typically have many duties whose violation may trigger civil and criminal liability. Candidates for managing director positions must therefore be informed of these risks and may want the company to take out appropriate insurance coverage.

In some countries (such as THE NETHERLANDS), it is also possible to use nominee directors who are employed by specialised service providers and may be used to fulfil local residency requirements. THE NETHERLANDS are also an example of a jurisdiction that allows one legal entity to function as managing director of another - so that effectively the managing director (natural person) of the managing director (legal entity) will run the company at stake.

5. Non-compete provisions

In Europe it is common for buyers to seek protection from (any) competition by the seller (and/or members of the management of the target company following their replacement) by means of non-complete provisions for a certain period (one to five years) - provided that an adequate remuneration is paid to the individual for observing such non-compete provisions.

Regional differences start with the formalities: In THE NETHERLANDS the non-compete clause must be in writing and the prohibited activities must be described as clearly as possible. In BELGIUM, GERMANY and ITALY non-compete clauses must, under penalty of nullity, be established in writing and must be drawn up individually for every employee (but not necessarily at the moment of the conclusion of the employment contract). It is essential that SPANISH non-compete clauses are expressly agreed (but not necessarily in writing). However, the written form of course makes it easier to prove their existence as well as the conditions agreed. Finally, in FRANCE a non-competition clause must be in writing and must be explicitly approved by the employee. If the clause is governed by a collective bargaining agreement, the employer shall secure in writing the proof that the employee was aware of its content.

On the subject matter there are also differences to be factored in, mostly established via local case-law. The common denominator is that non-compete clauses must be limited in time and/or region. In GERMANY for example, case law indicates that a non-compete for up to two years and confined to a reasonably determined geographical area (which will depend on the type of business and previous activities of the individual) will be enforceable. Additionally, it is worth mentioning that non-compete arrangement may be found in employment or service agreements of managing directors as well as in the underlying deal documentation, eg in a shareholders’ or share transfer agreement. In ITALY, according to Art. 2125 of the Civil Code, noncompetition clauses must also be limited in terms of duration (the maximum duration is three years for employees and five years for executives), territory (geographical reach), and subject matter (eg prohibited from working in a specific industry or for named competitors). According to FRENCH case law the non-compete clause must be essential to the protection of the company’s interests, limited in time, territory, activity and it must provide for a financial compensation of the employee during its whole term. These principles set forth by case-law apply unless collective bargaining agreements provide other specific limitations.

Special attention is required in case of distribution contracts: Art. 101 para. 1 of the Treaty on the Functioning of the European Union (TFEU) prohibits agreements with the purpose of restricting competition within the internal market. Post-term non-compete clauses prevent access to the market for former network distributors. Consequently, post-term non-compete clauses should be prohibited in distribution contracts. However, there are exceptions to this general rule (see Art. 101 para. 3 TFEU).

In contrast, legislation in certain states of the U.S. (eg in California) is very restrictive with respect to non-competes. They may be entirely prohibited for employees of the target company and/or only permissible in exceptional cases where an individual owns a significant percentage of the shares in the target company.

6. Regulatory approvals and/or transfer restrictions

6.1 Merger control

Amongst the regulatory approvals relevant in M&A transactions merger control probably is the most common, yet it is by no means the only one. Other governmental authorities such as foreign investment authorities may also have a say in the feasibility or timing of your deal.

6.2 Mandatory approval requirements

In PRC any foreign investment is subject (at least) to approval from the Ministry of Commerce or its local counterpart or other industry regulator, depending on the size of the investment and the sector concerned. To what extent foreign investment is permitted depends on the industry sector as set out in a catalogue published by the State Council of China and on policy concerns of the government. In some sectors there may be a legal requirement to invest through a joint venture with a local partner. Several types of legal entities are available depending on the investment. Any transfer of shares in a foreign-invested enterprise is subject to approval by the original approval authority and without this approval, the transfer is invalid. Therefore, in a CHINESE transaction, regulatory approvals must be introduced as closing condition to the transaction documentation. The formal approval from the regulator must be applied for once a binding agreement has been signed and be accompanied by an extensive set of documents including board and shareholder resolutions, company articles, audited financials, Foreign Investment Approval Certificate, current business license, a bank letter of credit, various documents regarding former and future directors. Needless to stress that preparing such an application is time consuming, it should be factored into the time line (and the budget) from the outset.

Several other jurisdictions have similar approval requirements for foreign investments. These include CANADA (review under the Investment Canada Act), AUSTRALIA (Foreign Investment Review Board (FIRB) review), and INDONESIA (Badan Koordinasi Penanaman Modal (BKPM) approval).

6.3 Prohibitions or restrictions on foreign investments

In other countries, even if no regulatory approvals are required, local authorities may prohibit a transaction in certain circumstances: In GERMANY new rules governing foreign investments were introduced in 2009 (and amended/reinforced thereafter). These apply to any acquisition of a direct or indirect shareholding of at least 25 % of the voting rights in a German company by a non-EU or non-EFTA acquirer, whether through a share transfer or some other acquisition structure. As a thumb rule , the Federal Ministry of Economics may investigate the matter within three months of signing and request further information on the transaction. Within two months of receiving such information, the Ministry may restrict or prohibit the transaction if it is considered to violate public policy considerations. Even though in practice acquisitions in certain industry sectors such as public infrastructure or highly sophisticated technology are more likely to arouse concern, application of the law is not restricted to certain industry sectors or certain types of investors and has thus become a standard topic in any many M&A transaction involving a German target. If prohibited, the underlying transaction becomes void. Consequently, to increase transaction certainty, it is recommended to await the outcome of the Ministry’s review. As an alternative, the parties may also apply for a clearance certificate even prior to signing. The clearance certificate is deemed to have been issued unless the Ministry initiates the review process within one month of receiving the application.

6.4 Foreign capital registration requirements

Some jurisdictions (such as BRAZIL) have special requirements for (i) the registration of investments by foreign investor in a local company or (ii) for certain financial transactions between local and offshore entities. A failure to comply with such registration rules from the outset may cause issues later down the road including restrictions on dividend payments or the remittance of any funds resulting from a termination of the investment. In PRC, a foreign invested enterprise must complete a foreign exchange registration with the State Administration for Foreign Exchange or its local counterparts.

Beyond these registration requirements, it may also be necessary to establish a special type of bank account with a domestic bank to be used for any payments into the country. Foreign investors often are not aware of these requirements and only discover that their investment is non-compliant with local law at a later stage once they try to remit any funds abroad or to divest or restructure their investment. Experience shows that any form of retroactive remediation of such a situation can be cumbersome and consume noticeable time and resources.

6.5 U.S. National Security Requirements

In the U.S. a governmental body called Committee on Foreign Investment in the United States is empowered to review transactions by which non-US citizens (or foreign organisations/governments) acquire control of an American business if and to the extent national security is at stake. This may be the case for critical infrastructure or certain technology. I am told by U.S. colleagues that the review of this U.S. authority has a very broad scope and, under the ultimate authority of the president of the United States, it can prohibit, suspend or impose conditions/restrictions on a transaction. To give a very recent example: In March 2018 President Donald Trump issued an order blocking the $117bn takeover of Qualcomm (U.S.) by Broadcom (Singapore), both chipmaking giants, saying it was necessary to protect national security.

7. Works council consultation requirements

Some jurisdictions, most of them in EUROPE, provide for far-reaching information and consultation rights of works councils or trade unions. While these are more frequent in asset transactions where employees transfer to a new employer, consultation rights also exist in cases where shares are sold, and this may be true for third party and intra-group transactions.

7.1 Dutch System

THE NETHERLANDS provide for particularly broad workers consultation schemes. Works councils usually exist within Dutch companies having 50 or more employees. Certain management decisions typical in M&A-transactions call for the consultation of the works council before they may be carried out. Consultation is required for the sale of a company, whether by way of a share or an asset deal, for taking out loans, granting security for third party debt, or pledging company shares. Surprisingly, the consultation requirement applies not only to third party but also intra-group transactions.

Consultation means that the works council must be fully informed of the reasons behind the proposed decision and its potential consequences for employees. The works council will then have a reasonable amount of time - usually two weeks to one month - to consider the matter before issuing either an unconditional positive or negative advice, or an advice with certain conditions attached to it. If the advice is negative or contains conditions to which the management does not agree, a one month waiting period starts to run during which management may not implement the decision and the works council may initiate court proceedings to prevent the implementation of the decision or reverse its consequences if already implemented. If there is no works council yet, employees may request the formation of a works council which will then have to be consulted.

The transaction may also require the prior notification to the Merger Committee of the Social and Economic Council of the Netherlands (SER) and the trade unions and the prior consultation of the trade unions. The unions do not have a veto right but may organize political opposition against a transaction.

If properly prepared and managed the consultation process may be conducted in a cooperative and expeditious manner but attention should be given to the implications early in the process to avoid unpleasant surprises or delays.

7.2 The French System

A similar requirement exists in FRANCE. Prior to entering into any agreement regarding the sale of a French company, management must inform the works council of the transaction and the prospective consequences for employees. If it fails to do so, the company and its management may be facing the imposition of a fine or, more importantly, the works council may file for an injunction.

7.3 Other Jurisdictions to Watch Out For

Many other European countries such as BELGIUM, DENMARK, FINNLAND, ITALY, GERMANY, NORWAY, POLAND, SPAIN, and the UK provide for employee information or consultation requirements in the case of asset transfers and some, for share transfers. Employee information or consultation may also be required in countries such as the PRC, SINGAPORE, INDONESIA, and the U.S. Consequently, employee notification or consultation requirements must be on the watch list of any lawyer advising on multi-jurisdictional M&A, financing and group restructuring transactions.

8. Transfer of undertaking; liabilities resulting from private pension funds

Some jurisdictions, most of them in Europe, provide for far-reaching information and consultation rights of works councils or trade unions. While these are more frequent in asset transactions where employees transfer to a new employer by operation of law, consultation rights also exist in cases where shares are sold, and this may be true for third party and intra-group transactions.

9. Material adverse change (MAC) conditions

When it comes to MAC-clauses the world seems to be divided into two camps: In the U.S. they are common; a condition triggered by a material adverse change of the target can measure changes during differing test periods (eg completion vs. signing, completion vs. last audited annual accounts). MAC clauses may be heavily negotiated and typically expressly preclude numerous items (eg geopolitical conditions, industry wide events) from establishing the existence of a MAC. Finally, I am told by U.S. colleagues that stand-alone MAC clauses have generally not been successfully asserted by purchasers in U.S. courts as a basis not to complete a transaction, but they may provide negotiating leverage.

In contrast, in UK, PRC, GERMANY, ITALY, FRANCE, and THE NETHERLANDS MAC clauses are rare. General or broad MAC-definitions are inexistent, if at all one will find narrowly defined business MACs limited to specific events and/or financial parameters. If the financing documentation provides for a MAC, it will probably also be reflected in the equity documentation.

10. Closing accounts vs. locked box

In EUROPE, in particular when dealing with Private Equity investors, locked box mechanisms are very popular. Parties agree on a fixed price (frequently based on a financial due diligence prior to signing) which is not subject to any subsequent adjustments. In such case the SPA includes covenants and indemnities to protect the value to be delivered at completion. In other words, the parties agree what is in the box and then lock it up - provided the box stays locked there are no adjusting payments to the price.

In contrast, in the U.S. the parties to a transaction regularly agree on detailed provisions how to determine the purchase price post-signing via financial adjustments. These adjust or true up the purchase price paid for a target following completion. An estimated amount of consideration is paid at completion with any balancing payment(s) (in most cases in either direction) being paid following the agreement or determination of the actual position. The actual position will usually be tested at the completion date, but the parties may select an alternative effective date for the true up (very common: a month end) and cover the risk period between the two with ordinary course undertakings and/or warranties.

11. Execution Formalities

In many jurisdictions, in particular those based on the civil law system, share transfers and pledges, corporate restructurings, asset transfers and real estate transactions, depending on the type of entity or transaction involved, may be valid only if notarization procedures are observed.

Civil law notarization is not to be confused with the mere authentication of a signature by a non-professional owning a limited license, such as a U.S. notary public. It means that the notary, a trained professional assuming a public office, incorporates the document into a notarial deed which he must review and finalize together with the parties. In some jurisdictions such as GERMANY, AUSTRIA or ITALY, the entire document must be read out aloud in the presence of the parties. In GERMANY, this also extends to attachments other than mere lists or numbers, such as reports, draft closing documents, and side agreements.

The reading requirement must be considered when budgeting for and timing the signing or closing of a transaction. To read lengthy documents together with all attachments may take several hours before the parties may sign the agreement. Where notarization is a requirement for other steps such as the signing of financing documents or the funding of a transaction, it may be necessary to start the notarization process the night before the main date of the transaction. Experienced M&A counsel will find ways to minimize the time required for reading by separating non-governing documents from the main agreement or arranging for the notarization of attachments separately and beforehand.

Notarization requirements play a role not only in the implementation of a transaction but also during due diligence. If contrary to a statutory requirement a transaction has not been properly notarized, a decision will have to be made whether the invalid transaction may retroactively be “healed” or must be re-executed by means of a confirmatory deed or in some other way.

12. Bring-down provisions, disclosure letter

It seems that there is neither a general nor a country-specific rule as to whether guarantees are given as at signing and/or repeated at completion. This will in the first place depend on the bargaining power of the parties. Sellers tend not to accept business guarantees as per completion for circumstances that may change after signing (eg no litigation). Accuracy of the guarantees is not a common condition to completion. Completion bring-down mechanics are sometimes used (eg if parties want to use disclosure letters to be given at completion).

13. Translations

Finally, remember that (certain) documents may need to be translated and that a decision will have to be made which language prevails (unless local law prescribes the use of a local/official language or in case documents will serve as a basis for local filings). For filing purposes translation by court-certified translators may be required. Please also remember to factor in time for translation (even the speediest professional translation service will not turn around a 60-page SPA translation in 24h). And if you ever tried simultaneous translations during negotiations you will understand why I would say that these should be avoided…