Advisory Board

  • Cai Hongbin
  • Peking University Guanghua School of Management
  • Peter Clarke
  • Barry Diller
  • IAC/InterActiveCorp
  • Fu Chengyu
  • China National Petrochemical Corporation (Sinopec Group)
  • Richard J. Gnodde
  • Goldman Sachs International
  • Lodewijk Hijmans van den Bergh
  • De Brauw Blackstone Westbroek N.V.
  • Jiang Jianqing
  • Industrial and Commercial Bank of China, Ltd. (ICBC)
  • Handel Lee
  • King & Wood Mallesons
  • Richard Li
  • PCCW Limited
  • Pacific Century Group
  • Liew Mun Leong
  • Changi Airport Group
  • Martin Lipton
  • New York University
  • Wachtell, Lipton, Rosen & Katz
  • Liu Mingkang
  • China Banking Regulatory Commission (CBRC)
  • Dinesh C. Paliwal
  • Harman International Industries
  • Leon Pasternak
  • BCC Partners
  • Tim Payne
  • Brunswick Group
  • Joseph R. Perella
  • Perella Weinberg Partners
  • Baron David de Rothschild
  • N M Rothschild & Sons Limited
  • Dilhan Pillay Sandrasegara
  • Temasek International Pte. Ltd.
  • Shao Ning
  • State-owned Assets Supervision and Administration Commission of the State Council of China (SASAC)
  • John W. Snow
  • Cerberus Capital Management, L.P.
  • Former U.S. Secretary of Treasury
  • Bharat Vasani
  • Tata Group
  • Wang Junfeng
  • King & Wood Mallesons
  • Wang Kejin
  • China Banking Regulatory Commission (CBRC)
  • Wei Jiafu
  • Kazakhstan Potash Corporation Limited
  • Yang Chao
  • China Life Insurance Co. Ltd.
  • Zhu Min
  • International Monetary Fund

Legal Roundtable

  • Dimitry Afanasiev
  • Egorov Puginsky Afanasiev and Partners (Moscow)
  • William T. Allen
  • NYU Stern School of Business
  • Wachtell, Lipton, Rosen & Katz (New York)
  • Johan Aalto
  • Hannes Snellman Attorneys Ltd (Finland)
  • Nigel P. G. Boardman
  • Slaughter and May (London)
  • Willem J.L. Calkoen
  • NautaDutilh N.V. (Rotterdam)
  • Peter Callens
  • Loyens & Loeff (Brussels)
  • Bertrand Cardi
  • Darrois Villey Maillot & Brochier (Paris)
  • Santiago Carregal
  • Marval, O’Farrell & Mairal (Buenos Aires)
  • Martín Carrizosa
  • Philippi Prietocarrizosa & Uría (Bogotá)
  • Carlos G. Cordero G.
  • Aleman, Cordero, Galindo & Lee (Panama)
  • Ewen Crouch
  • Allens (Sydney)
  • Adam O. Emmerich
  • Wachtell, Lipton, Rosen & Katz (New York)
  • Rachel Eng
  • WongPartnership (Singapore)
  • Sergio Erede
  • BonelliErede (Milan)
  • Kenichi Fujinawa
  • Nagashima Ohno & Tsunematsu (Tokyo)
  • Manuel Galicia Romero
  • Galicia Abogados (Mexico City)
  • Danny Gilbert
  • Gilbert + Tobin (Sydney)
  • Vladimíra Glatzová
  • Glatzová & Co. (Prague)
  • Juan Miguel Goenechea
  • Uría Menéndez (Madrid)
  • Andrey A. Goltsblat
  • Goltsblat BLP (Moscow)
  • Juan Francisco Gutiérrez I.
  • Philippi Prietocarrizosa & Uría (Santiago)
  • Fang He
  • Jun He Law Offices (Beijing)
  • Christian Herbst
  • Schönherr (Vienna)
  • Lodewijk Hijmans van den Bergh
  • De Brauw Blackstone Westbroek N.V. (Amsterdam)
  • Hein Hooghoudt
  • NautaDutilh N.V. (Amsterdam)
  • Sameer Huda
  • Hadef & Partners (Dubai)
  • Masakazu Iwakura
  • TMI Associates (Tokyo)
  • Christof Jäckle
  • Hengeler Mueller (Frankfurt)
  • Michael Mervyn Katz
  • Edward Nathan Sonnenbergs (Johannesburg)
  • Handel Lee
  • King & Wood Mallesons (Beijing)
  • Martin Lipton
  • Wachtell, Lipton, Rosen & Katz (New York)
  • Alain Maillot
  • Darrois Villey Maillot Brochier (Paris)
  • Antônio Corrêa Meyer
  • Machado, Meyer, Sendacz e Opice (São Paulo)
  • Sergio Michelsen Jaramillo
  • Brigard & Urrutia (Bogotá)
  • Zia Mody
  • AZB & Partners (Mumbai)
  • Christopher Murray
  • Osler (Toronto)
  • Francisco Antunes Maciel Müssnich
  • Barbosa, Müssnich & Aragão (Rio de Janeiro)
  • I. Berl Nadler
  • Davies Ward Phillips & Vineberg LLP (Toronto)
  • Umberto Nicodano
  • BonelliErede (Milan)
  • Brian O'Gorman
  • Arthur Cox (Dublin)
  • Robin Panovka
  • Wachtell, Lipton, Rosen & Katz (New York)
  • Sang-Yeol Park
  • Park & Partners (Seoul)
  • José Antonio Payet Puccio
  • Payet Rey Cauvi (Lima)
  • Kees Peijster
  • COFRA Holding AG (Zug)
  • Juan Martín Perrotto
  • Uría & Menéndez (Madrid/Beijing)
  • Philip Podzebenko
  • Herbert Smith Freehills (Sydney)
  • Geert Potjewijd
  • De Brauw Blackstone Westbroek (Amsterdam/Beijing)
  • Qi Adam Li
  • Jun He Law Offices (Shanghai)
  • Biörn Riese
  • Jurie Advokat AB (Sweden)
  • Mark Rigotti
  • Herbert Smith Freehills (Sydney)
  • Rafael Robles Miaja
  • Robles Miaja (Mexico City)
  • Alberto Saravalle
  • BonelliErede (Milan)
  • Maximilian Schiessl
  • Hengeler Mueller (Düsseldorf)
  • Cyril S. Shroff
  • Cyril Amarchand Mangaldas (Mumbai)
  • Shardul S. Shroff
  • Shardul Amarchand Mangaldas & Co.(New Delhi)
  • Klaus Søgaard
  • Gorrissen Federspiel (Denmark)
  • Ezekiel Solomon
  • Allens (Sydney)
  • Emanuel P. Strehle
  • Hengeler Mueller (Munich)
  • David E. Tadmor
  • Tadmor & Co. (Tel Aviv)
  • Kevin J. Thomson
  • Barrick Gold Corporation (Toronto)
  • Yu Wakae
  • Nagashima Ohno & Tsunematsu (Tokyo)
  • Wang Junfeng
  • King & Wood Mallesons (Beijing)
  • Tomasz Wardynski
  • Wardynski & Partners (Warsaw)
  • Rolf Watter
  • Bär & Karrer AG (Zürich)
  • Xiao Wei
  • Jun He Law Offices (Beijing)
  • Xu Ping
  • King & Wood Mallesons (Beijing)
  • Shuji Yanase
  • OK Corporation (Tokyo)
  • Alvin Yeo
  • WongPartnership LLP (Singapore)

Founding Directors

  • William T. Allen
  • NYU Stern School of Business
  • Wachtell, Lipton, Rosen & Katz
  • Nigel P.G. Boardman
  • Slaughter and May
  • Cai Hongbin
  • Peking University Guanghua School of Management
  • Adam O. Emmerich
  • Wachtell, Lipton, Rosen & Katz
  • Robin Panovka
  • Wachtell, Lipton, Rosen & Katz
  • Peter Williamson
  • Cambridge Judge Business School
  • Franny Yao
  • Ernst & Young

Monthly Archives: June 2013

Chinese Update: How U.S. – Listed Chinese Companies Should Respond to Accounting Fraud Allegations

Editors’ Note:  Susan Ning, a member of XBMA’s Legal Roundtable, contributed this paper.  Ms. Ning heads King & Wood Mallesons’ International Trade and Antitrust and Competition Group and is widely recognized as one of the leading experts in the field, with many years of experience working with MOFCOM to secure merger clearance.  This article was authored by King & Wood Mallesons partners Harry Liu and Meg Utterback, and associate Yu Simin, the firm’s Dispute Resolution Group, Shanghai Office.
  • Since the end of 2010, a number of China-based companies that have engaged in reverse mergers were accused of committing accounting fraud, resulting in a suspension in trading or even delisting. They have also been under investigation by U.S. authorities for violating securities laws or found themselves targeted by class action lawsuits represented by U.S. plaintiffs’ lawyers.  This article introduces methods of conducting internal investigations, and building more robust corporate governance and internal controls, as an effective response to head off claims of improper conduct .
  • A successful internal investigation is critical for a troubled company to maintain its listing status. To minimize negative impacts brought about by the internal investigation, the audit committee should first formulate a well thought-out plan.  The goal is to carry out a thorough probe while at the same time avoiding intrusive obstruction over the company’s daily business operations.
  • In our experience, many Chinese companies accused of committing accounting fraud did not fabricate sales revenues or profit margins. However, almost all of them are not in strict compliance with legal and accounting rules, such as setting up off-the-book accounts, using the same underlying transaction or project to obtain multiple bank loans, evading of China’s foreign exchange control regime, and borrowing from “shadow banks”.
  • The company’s full cooperation is the key. In many internal investigations we have conducted, we find that Chinese companies are still lagging behind their Western peers in terms of transparency.
  • Strengthening internal controls is the best way to root out improper conduct that will attract short-sellers’ attacks, and when the company becomes a target of U.S. regulatory inquiries or plaintiff’s law firms, a properly conducted internal investigation coupled with a successful public relations campaign is the best proactive approach to bring the company out of the legal morass

Main Article:

In the past few years, a reverse merger has been a popular way for China-based companies to access U.S. capital markets. Since the end of 2010, a number of companies that have engaged in such mergers were accused of committing accounting fraud, resulting in a suspension in trading or even delisting. They have also been under investigation by U.S. authorities for violating securities laws or found themselves targeted by class action lawsuits represented by U.S. plaintiffs’ lawyers. Most of these besieged companies were found to be lacking robust corporate governance and internal controls. The purpose of this article is to introduce our experience in conducting internal investigations as an effective response to head off claims of improper conduct. The author will outline several commonly-seen irregularities revealed during the course of these investigations, highlighting the need of U.S.-listed Chinese companies to enhance their compliance mechanisms.

I. Audit Committee Initiating Internal Investigations

When a company is facing U.S. government inquiries, or brought into class action lawsuits, or if such a possibility is looming ahead, the company should investigate as soon as practical to determine whether the claims and allegations are true. Launching an internal investigation demonstrates to the outside world that the company is managing the crisis in a responsible and proactive way. If the outcome of a properly conducted investigation is positive, it affords the company the best evidence to convince regulators to suspend inquiries, and seek relisting.

Internal investigations are initiated typically as a result of the following events:

a. Short-selling investment research firms usually look for and identify discrepancies between the company’s U.S. disclosure and its corporate annual filings maintained at Chinese Administration of Industry and Commence (AIC), and then issue research reports based on these findings, accusing the company of fraudulent accounting practices;

b. The company’s external auditor has suspicion of accounting fraud during its annual auditing, but cannot obtain satisfactory explanations by the company, or is even obstructed from continuing audit work. The auditor resigns, resulting in delayed submission of the company’s audited quarterly or annual filings, in turn triggering a halt in trading or delisting;

c. The company’s business competitors or disgruntled employees make anonymous complaints to the Securities Enforcement Commission (SEC) and the stock exchange where the company’s shares are bought and sold;

d. Occasionally, the SEC may initiate investigations without first being tipped off.  For instance, in July of 2012, SEC started its probe into New Oriental Education’s VIE structure, and the day after the SEC’s announcement of its investigation, U.S.-based short-selling firm Muddy Water issued its research report questioning New Oriental Education’s accounting practices.

Most U.S.-listed Chinese companies are accused of fictitious revenue records, fabricating cash balance and account receivables, undisclosed related party transactions, and unlawful lending and borrowing practices.

For listed companies, an internal investigation is normally launched by an audit committee created by the board of directors. The audit committee first hires a U.S. law firm to lead the investigation. Because the majority of the investigation work is expected to be carried out in China, the U.S. law firm would engage a Chinese law firm, and typically, a reputable international accounting firm’s China-based affiliate. Because members of the audit committee are mostly comprised of independent directors, and due to the high level of professional ethics expected for legal counsels’ accountants, final findings made by them have a high likelihood of being accepted by U.S. authorities. Their findings become the factual foundation to convince the government to drop charges.

A successful internal investigation is critical for a troubled company to maintain its listing status. To minimize negative impacts brought about by the internal investigation, the audit committee should first formulate a well thought-out plan.  The goal is to carry out a thorough probe while at the same time avoiding intrusive obstruction over the company’s daily business operations. The remainder of this article will briefly discuss an internal investigation’s general procedure, and some tips.

II. Walking Through the Internal Investigations Process

A. Initiating Internal Investigations

After forming an investigation team comprising an army of counsels and accountants, the first task is identifying issues. They are chiefly based on the allegations and suspicions raised by the short-selling firms, government authorities, public media, or former auditors.  With these issues in mind, the investigation team formulates a road map.

The whole process typically takes four months or even more to conclude. Since the stock exchange staff members would not suspend their delisting proceedings simply because of the company’s initiation of an internal probe, the investigation team must prioritize its work and focus on the most serious allegations, such as the veracity of the company’s trading records and balance sheet. It is well advised to aim at delivering an interim report within the first two months of the internal investigation, with an attempt to produce preliminary yet substantiated findings on those most damaging accusations. If the investigation team can successfully demonstrate that it has been working diligently and vigorously, but still could not unearth any serious accounting fraud, the stock exchange staff members may be persuaded to suspend their delisting proceedings awaiting the team’s final report.

The investigation road map should also take into account the pace of the SEC inquiries.  If the SEC has issued subpoenas ordering the company to deliver commercial and accounting records for its review, the internal investigation team is in a better position than the company’s management to collect documentation required for submission.

B. Document Review

The first step of any internal investigation is to collect the company’s documents including electronic files saved on computers used by executives and key employees, including the president, general manager, finance director, production manager, sales manager, and administrative director, etc. Electronic document retrieval is generally performed by the accountants as they possess the electronic discovery software to accomplish this job. If one of the key issues to be investigated is related to verification of sales records, the accountants will also retrieve data from computers used by employees from the sales and finance departments. The degree of cooperation demonstrated by the company reflects whether the company is trying to cover up any evidence of accounting fraud.

The amount of data collected from dozens of computer hard drives is quite significant, typically amounting to several million copies of electronic files and e-mails. Junior members of the investigation team would spend a week or so performing preliminary document review, with the aim of eliminating irrelevant files. Documents potentially relevant to the issues are tagged and categorized into different “issue folders”. The contents of key documents are also summarized. Even after the initial screening, the number of files left would still be in the range of 10,000. If the company under investigation is a production enterprise, most of the documents collected would be related to raw material purchase, product manufacturing and sales records. It is the accountants’ job to pull out the company’s physical books and records, and make verification against the original sales and revenue data saved on the computers.

While the accountants are retrieving and screening electronic files, the lawyers’ job is to request and review corporate files such as contracts and transactional documentation. It is very unlikely that the company could hand over all the requested document in one batch, we recommend using excel forms to track which documents have been provided, and which are still outstanding. This also makes it easier to add new document requests to the list as the investigation reveals more sub-issues to be followed up.

 

C. Interviews with Employees and Third Parties

At the same time the document reviewing process is underway, the investigation team should conduct a first round of interviews with the company’s senior executives.  It is not recommended to directly delve into the issues. The purpose is rather to understand the corporate structure, management hierarchy, manufacturing process, transaction patterns, sources of financing, so that the investigation team can understand the documents they are reviewing.

Following the completion of document review and the first round of employee interviews, the investigation enters its key stage – external interviews with the company’s financiers, guarantors, related parties, suppliers and customers. Taking manufacturing companies as an example, the focal point of US short-sellers’ accusations is on the company’s sales revenue disclosures. To verify the veracity of sales transaction records, the investigation team must conduct interviews with the company’s customers, asking questions about the previous transactions. Aside from interviewing these customer companies’ supply managers, the accountants should also conduct sampling by reviewing selected accounting records kept by the customers, as a way to confirm whether they match with the records obtained from the company. Pertinent records normally include transportation vouchers, inventory entries, invoices, payment receipts, etc.

During this process, the investigation team should try to avoid causing too much disruption to the company’s business relations with its customers and bankers. If the questions asked are considered improper or even offensive, it would not only impede the effectiveness of the investigation process, it may also end up jeopardizing the company’s source of revenues. Some U.S. attorneys are skeptical about the independence of external interviews arranged by the company’s management.  In our experience, however, appearing at a third party’s business premises without prior announcement actually increases the chance of obtaining either valueless or untruthful information. The interviewees are not mentally prepared to answer intrusive questions about their business and accounting practices. As many domestic companies more or less have accounting irregularities, when encountered with unscheduled meetings, some interviewees’ first defensive mechanism is to hide or even to lie about the business transactions between them and the company. This causes serious issues on the accuracy of the information obtained.

Having the company’s management arrange third party interviews does not mean the investigation team will accept the arrangement made without any reservation. During the document review stage, we have collected the company’s key customers’ business addresses.  Sometimes, it is advisable to hire a professional investigator to verify these addresses. The investigation team should not take information received from the company at face value. As we have learned from past experience, some Chinese companies do create fictitious customers and their legal addresses as a way to defraud external auditors. That said, not every discrepancy between the customers’ real operating address and its AIC-recorded addresses mean it is a fraud.It is not uncommon for some Chinese companies to have their actual business operation premises located at a different place than their registered legal addresses, in order to receive local government incentives from places where they register their legal addresses. Sometimes a company also finds it difficult to move its original registered legal address because the local authorities want to retain its tax contribution. As a result, many Chinese companies have to separate their actual business addresses from their registered addresses.

D. Verifying Sales Records

Not all apparent discrepancies can be easily explained by the investigation team. In one case, one of a company’s top-five customers suddenly stopped buying products at the beginning of 2011. Because the timing was quite close to the FY10 annual audit, the former external auditor decided to conduct a thorough review of that customer (“Customer A”). Unfortunately, because most of the previous transactions were concluded by telephone or fax, and the company’s responsible sales person had left, no one at the company knew much about Customer A. When the former external auditor visited Customer A’s business address recorded on the company’s transaction documents, it turned out that it was not a business address, and phone calls made to Customer A’s regular contact person always went unanswered. The company could not provide a satisfactory explanation, and eventually the external auditor resigned.

Following the former auditor’s resignation, the company’s audit committee swiftly engaged our firm and initiated an internal investigation.  During our external interview with one of the company’s other customers situated in Southern China (“Customer B”), we realized that the missing contact person of Customer A was actually Customer B’s employee. That employee purchased products from the company under the cover of Customer A, and then re-sold the same products to his employer Customer B and cut decent profits in between. When Customer B realized it had been defrauded by its own employee, that person resigned and closed down Customer A’s business. Unfortunately, Customer B did not communicate its findings to the company. We pulled the sales records between Customer A and Customer B, and it turned out that they match the sales records between the company and Customer A.

Based on our experience, very few companies dare fabricate their sales figures. It is more likely they exaggerated the company’s growth potential and business model, or concealed misconduct falling in so-called “grey areas”, for example, mischaracterizing trading customers as production customers, or failing to disclose indirectly-controlled related parties. A large portion of such non-disclosure was not done purposely but rather due to ignorance of rules imposed on U.S. listed companies.

E. Concluding Investigation

After concluding external interviews, the investigation team will conduct a final round of internal interviews with the company’s management personnel, major shareholders, and financial advisors who assisted the company in the listing. They will be questioned on the issues and problems identified during document review and external interviews, and given a chance to provide explanations and clarifications. The whole process normally takes one or two weeks. After wrapping up these interviews, the investigation team will prepare a final investigation report and submit it to the audit committee.

In our experience, many Chinese companies accused of committing accounting fraud did not fabricate sales revenues or profit margins. However, almost all of them are not in strict compliance with legal and accounting rules, such as setting up off-the-book accounts, using the same underlying transaction or project to obtain multiple bank loans, evading of China’s foreign exchange control regime, and borrowing from “shadow banks”.

III. Comments

A. Enhance Internal Control, Foster Corporate Governance

We have noticed that many investment banks and financial advisors that helped a company gain listing in the U.S. have failed to build a strong internal control and compliance infrastructure for the company.  Many China-based companies’ executives know very little about rules and regulations that need to be strictly followed.  Although they hire U.S.-trained Chinese financial advisors as CFOs, many of the CFOs reside in the U.S. for most of the year, and mainly focus on raising capital in the U.S. securities market.  As a result, they have to rely on second-hand information passed from the company’s sometimes less competent and trustworthy local accounting managers.

B. Crisis Management

When a company becomes a short-sellers’ target or is under investigation by U.S. regulators, the company must stand firm against these short-selling institutions, make timely announcements rebuking unfounded accusations, and if necessary, file defamation lawsuits against slanderers. When Evergrande Real Estate was hit by short-sellers in June 2012, its crisis management is an excellent example of how a company should react when faced with adversity. At that time, U.S. short-selling firm Citron made serious accusations that Evergrande committed accounting fraud and had already been insolvent.  Evergrande swiftly made public statement rebuking Citron’s allegations, followed by a more detailed and thorough clarification the next day. Within the next few days, Evergrande also garnered support from Citibank, Deutsche Bank, Bank of America Merrill Lynch, JP Morgan Chase, Credit Suisse, UBS, Macquarie Securities and DBS Bank.  They unanimously gave Evergrande shares a “buy” or even higher rating. Evergrande’s shares then rebounded.

Even if a company is gaining positive references in the media, an internal investigation is still very necessary in order to provide to the outside world substantiated evidence that the company is clean. The company’s full cooperation is the key. In many internal investigations we have conducted, we find that Chinese companies are still lagging behind their Western peers in terms of transparency. For example, in one case, we obtained incomplete records showing that the company maintained an off-the-book account. When we questioned the responsible accounting manager, his admission of wrongdoing was initially limited to the records we had found, and he denied there have been any other transactions relating to that account.  However, we later discovered the full extent of the records through electronic discovery process. Although most of the income and expenses relating to the account are legitimate, the stock exchange where the company’s shares were traded eventually refused to allow the company to resume trading, and based its decision mainly on the company’s intentional withholding of information from the internal investigation team.

IV. Conclusion

The crisis that hit so many US-listed Chinese companies in 2011 may be gone, but the compliance risks remain.  New Oriental Education became the latest victim of U.S. short-sellers in July 2012.After the SEC announced it commenced investigations into the company’s variable interest entity structure, it had been named in seven class action lawsuits in less than two months.  Strengthening internal controls is the best way to root out improper conduct that will attract short-sellers’ attacks, and when the company becomes a target of U.S. regulatory inquiries or plaintiff’s law firms, a properly conducted internal investigation coupled with a successful public relations campaign is the best proactive approach to bring the company out of the legal morass.

(This article was originally written in Chinese, and the English version is a translation.)

The views expressed herein are solely those of the author and have not been endorsed, confirmed, or approved by XBMA or any of the editors of XBMA Forum, nor by XBMA’s founders, members, contributors, academic partners, advisory board members, or others. No inference to the contrary should be drawn.

AUSTRALIAN UPDATE – Disclosure of Informal Approaches by Bidders

Editors’ Note: This report was contributed by Philip Podzebenko, a member of XBMA’s Legal Roundtable and a member of Herbert Smith Freehills’ Corporate Group, which is at the forefront of developments shaping Australia’s corporate landscape. The author is Rodd Levy, partner, at Herbert Smith Freehills. Rodd is a member of Herbert Smith Freehills’ Corporate Group, specialising in mergers and acquisitions and is the author of Takeovers Law & Strategy, 4th edn.

Highlights:

  • Recently, there has been a trend towards Australian listed companies disclosing to the market initial confidential approaches by bidders because of concerns that this was necessary to satisfy their continuous disclosure obligations under the Australian Stock Exchange’s listing rules.
  • Changes to the Australian Stock Exchange’s listing rules and guidance taking effect from 1 May 2013 have sought to clarify the position. In the absence of a leak, a potential bidder and target should be able to conduct negotiations and due diligence without the target having to make disclosure to the market until execution of a binding implementation agreement.

Main Article:

It has become unusual for a formal takeover bid in Australia to be announced on a hostile basis without at least some prior engagement with the target board. Generally, bidders (and their financiers) are increasingly cautious, seeking to conduct due diligence before proceeding to minimise risk.

Therefore, it has become the frequent practice for an interested party to submit to the target board a confidential non-binding indicative offer expressing interest in acquiring the entity (usually by scheme of arrangement). The indicative offer is typically conditioned on satisfactory due diligence being carried out and the target board recommending that shareholders support the transaction.

Disclosure requirements

The receipt of such an indicative offer would put target directors in an invidious position due to their continuous disclosure obligations under the listing rules of the Australian Stock Exchange.

The general disclosure rule requires a listed entity to disclose immediately all information that a reasonable person would expect to have a material effect on the price or value of the entity’s securities.

There is a carve-out such that no disclosure is required if all of the following conditions are satisfied:

  • the information concerns an incomplete proposal or negotiation;
  • the information remains confidential; and
  • a reasonable person would not expect it to be disclosed.

In recent years, boards increasingly felt obliged to disclose the receipt of an indicative offer. This was to avoid criticism from shareholders and the market for withholding information and also because frequently the existence of the indicative offer would leak and the entity would then be on the back foot and forced to disclose the letter to ensure an informed market. Many boards thought it easier to simply announce the indicative offer on receipt, even though that carried its own disadvantages, such as creating share price volatility and attracting hedge funds on to the register due to inevitable speculation that a bid would eventuate – all of which put the entity under additional pressure to engage with the bidder and agree a transaction.

The trend to disclose was so pronounced that concerns were raised that the disclosure carve-out would not apply, as it could not be said with certainty that, given the emerging practice, a reasonable person would not expect the approach to be disclosed.

This trend also resulted in potential bidders being put in a difficult position as they could not be certain that the target board would engage with them before announcing their approach and, effectively, putting the target in play.

New ASX Rule and Guidance

With effect from 1 May 2013, the ASX has brought into force a revised listing rule and accompanying guidance note which is intended to ease the pressure on listed entities to announce the receipt of an indicative offer.

The guidance note sets out the ASX’s attitude to disclosure at certain steps that may occur as a potential bidder engages with the target on a proposal. These are as follows:

Step 1       A potential bidder submits a confidential non-binding indicative offer to the listed entity proposing a merger by way of scheme of arrangement. The offer is expressed to be subject to a number of conditions, including the completion of due diligence and the target’s board unanimously recommending the transaction in the absence of a higher offer.

Step 2       The target’s board meets to consider the offer and resolves to reject it on the basis it undervalues the company and is opportunistic. The company’s advisers write a private and confidential letter to the potential bidder confirming the rejection.

Step 3       A week later a revised confidential non-binding indicative offer is proposed at a higher price, but otherwise on similar conditions.

Step 4       This time, the target’s board resolves to enter into negotiations about the possible transaction and writes to the bidder confirming the directors are prepared to recommend such a proposal in the absence of a higher offer, subject to final transaction terms being satisfactory.

Step 5       The parties sign a confidentiality agreement with a view to the bidder commencing due diligence.

Step 6       The potential bidder completes its due diligence and indicates that it is prepared to proceed with the transaction subject to the negotiation and signing of a legally binding implementation agreement

Step 7       The parties complete their negotiations and sign an implementation agreement.

The ASX’s view is that it is only at Step 7 that any disclosure is required under the listing rules.

This, of course, assumes that all of the steps remain confidential. If a leak occurs and confidentiality is lost, immediate disclosure, or a trading halt, is required to safeguard the market.

Implications

It is too early to reach any conclusions about whether the revised ASX rule is having the intended effect. However, the design of the rule and the guidance note should give target directors greater comfort to deal with an indicative offer on a proper basis without worrying that they will be criticised if they do not immediately announce they have received it.

Coupled with the absence of a put up or shut up rule in Australia, the revised rule should also encourage potential bidders to approach the target with greater certainty that their proposal will not be released prematurely by a target on the basis that disclosure was required by the listing rules.

For these reasons, we expect this revised approach of the ASX to be conducive to a more active market for corporate control.

The views expressed herein are solely those of the author and have not been endorsed, confirmed, or approved by XBMA or any of the editors of XBMA Forum, nor by XBMA’s founders, members, contributors, academic partners, advisory board members, or others. No inference to the contrary should be drawn.

Polish Update – The Importance of Analyzing Legal Title to Shares in the Acquisition of Polish Companies

Editor’s Note: This update comes from Tomasz Wardyński, founding partner of Wardyński & Partners and a member of XBMA’s Legal Roundtable.  The co-authors of this article: Izabela Zielińska-Barłożek, co-head of the Mergers & Acquisitions Practice, and Jarosław Grykiel, PhD, specialize in Polish corporate law in cross-border transactions.

Executive summary

Before the transaction, the buyer usually performs a legal examination of the company whose shares are to be traded (directly or indirectly, for example through the acquisition of shares in the parent company). When assessing the legal importance of examining the legal title to shares it should be kept in mind that in Polish law there are no general legal remedies that allow the buyer acting in good faith to acquire ownership of shares where the seller is not the owner of such shares.  As a consequence, only a proper examination of the legal title to the shares will allow the investor to properly assess the situation (in particular the right of the seller to dispose of the shares) and to guard against possible adverse effects of irregularities in the acquisition of shares by the seller or his legal predecessors.

Main Article:

The vast majority of transactions on the Polish market (including some international transactions involving Polish companies) are “share deal” transactions, i.e., transactions which consist of the acquisition by the investor of share rights in a company belonging to the seller.

Before the transaction is signed, the buyer usually performs a legal audit of the company whose shares are to be traded directly or indirectly (for example through the acquisition of shares in the parent company). The scope of the legal audit covers many different areas, often dependent on the objects of the company. As more and more often we observe the practice of investors limiting the scope of the due diligence examination or even skipping this step in the transaction altogether, we haste to point out that there exist certain issues whose proper examination is always necessary in this type of transactions, and that it is in the best interests of the investor. One example is precisely the examination of the seller’s legal title to the shares. It consists of determining whether the seller (or the company that is acquired, in the case of more complex international transactions) has sufficient legal title to shares in the Polish company, and therefore whether the seller is their rightful owner.

When assessing the legal importance of examining the legal title to shares it should be kept in mind that in Polish law there are no general legal remedies that allow the buyer acting in good faith to acquire ownership of shares in a situation where the seller is not owner of such shares. A general principle applies in this respect according to which no one can transfer on another party more rights than he himself possesses. Thus, if the seller of the shares or any of his legal predecessors has not properly acquired the title to the shares (has not become their owner), then the buyer also cannot effectively acquire that title.

Contrary to the frequently repeated erroneous opinion, listing the given entity as a shareholder in a publicly accessible enterprise register kept by a Polish court will not protect the buyer acting in good faith in a way that, for example, a buyer of real estate is protected in connection with listing the seller in the land and mortgage register kept for that real estate. Polish law does not provide for a warranty of public credibility of enterprise registers in the meaning in which this concept operates in relation to land and mortgage registers. Besides, protective instruments contained in the rules governing entries in the enterprise register (including the inability to evoke certain facts by the entity listed in the register, the presumption of common knowledge of register entries and the presumption of veracity of data subject to entry in the enterprise register) have been settled rather vaguely and are the subject of controversy both in doctrine and in jurisprudence. For this reason alone, public enterprise registers cannot form the basis for the formulation of clear-cut conclusions in this area. In addition, as mentioned above, in the case of the acquisition of shares, Polish law does not provide for the so-called warranty of public credibility of enterprise registers modeled on the regulations governing land and mortgage registers.

The need for the presentation of the legal title to shares received in a correct manner from legal predecessors makes it so that only a thorough examination of the full “history” of the turnover of shares in a limited liability company, covering all transactions that involved those shares since the company’s foundation until their latest disposal, can give a complete picture of the legal title to shares in the company and answer the question whether (i) the seller is authorized to sell those shares or (ii) the divested company actually owns shares of the Polish company in its assets. Without such thorough examination of the legal title to shares, their buyer can never be sure if he had effectively acquired those shares from the seller (even if the seller has 100% interest in the company and is listed as the sole shareholder in the enterprise register). As the trend in the past few years has been for investors to limit the scope of the legal examination, it should be emphasized once again that is not enough to investigate the legal title to shares only in the given period (e.g., during the course of five years before the planned transaction). For if before that period certain irregularities have taken place (e.g., shares were transferred ineffectively), those irregularities will have an impact on the disposal of those shares at a later date.

It does not matter how long ago share sale irregularities occurred. In contrast to objects (movable or immovable), Polish law does not provide for the possibility of acquiring the ownership of shares in a limited liability company through acquisitive prescription. In practice there have been cases where an entity would act in the company as the sole shareholder for over a decade, when in fact it never successfully acquired the ownership of shares in that company since agreements under which those shares were acquired by its legal predecessors proved to be invalid.

In analyzing the issue of legal title to shares it should also be noted that there are many different conditions provided for in Polish law which can determine the invalidity of the acquisition of shares in a limited liability company. They relate both to the form required for an effective transfer of shares, consents required for such transfer (e.g., in the form of a resolution of the general meeting of shareholders or of the company supervisory board), or to general prohibitions on alienating or acquiring shares under certain circumstances. Some conditions are often very difficult to grasp. For example, the general prohibition on the acquisition of shares owned by limited liability companies also applies to the acquisition of shares in the parent company by a subsidiary (Art. 200 of the Commercial Companies Code). A violation of this prohibition invalidates the acquisition. It should be remembered that the relationship of dependency and domination is treated very broadly in Polish law and is by no means limited to share dependencies. For example, companies on the boards of which sit the same people are mutually dominant and dependent (in the absence of other links referred to in Art. 4.1.4 of the Commercial Companies Code).

In summing up our considerations it can be concluded that, in the absence in Polish law of relevant legal remedies allowing the acquisition of shares in a limited liability company from an unauthorized party by a buyer acting in good faith, only a proper examination of the legal title to the shares will allow the investor to properly assess the situation (in particular the right of the seller to dispose of the shares) and to guard against possible adverse effects of irregularities in the acquisition of shares by the seller or his legal predecessors. If the transaction concerns shares in a Polish limited liability company, simply dealing with the absence of the legal title or with its defectiveness by way of the seller’s representations and warranties or claims for damages available to the buyer is totally inadequate. These issues are certainly important to every investor planning to acquire shares in a Polish limited liability company and contemplating the need to conduct a legal examination.

Additional articles on the legal aspects of mergers and acquisitions in Poland can be found on our Transactions Portal.

The views expressed herein are solely those of the author and have not been endorsed, confirmed, or approved by XBMA or any of the editors of XBMA Forum, nor by XBMA’s founders, members, contributors, academic partners, advisory board members, or others. No inference to the contrary should be drawn.

UK UPDATE – Recent Changes to the UK’s City Code on Takeovers and Mergers

Editors’ Note:  Contributed by Nigel Boardman, a partner at Slaughter and May and a founding director of XBMA.  Mr. Boardman is one of the leading M&A lawyers in the UK with broad experience in a wide range of cross-border transactions.

Executive Summary:  Recent amendments to the UK’s City Code on Takeovers and Mergers, the main rules governing takeovers in the UK, are discussed below.  The most significant changes resulting from these amendments are: (i) it will allow offerors to engage in early and have increased involvement with the offeree’s pension trustees in an offer; and (ii) all UK, Channel Islands and Isle of Man incorporated public companies trading on an multilateral trading facility in the UK, will be subject to the code, regardless of residence of central management and control.

Main Article:

Introduction

The Code Committee of the Takeover Panel has published Response Statements setting out amendments to the Takeover Code (“Code”) following its consultation on extending certain rights of employee representatives to the trustees of offeree company pension schemes and the rules for determining the companies that are subject to the Code.

In summary, the most significant changes as a result of the amendments are: (i) it will allow offerors to engage in early and have increased involvement with the offeree’s pension trustees in an offer; and (ii) all UK, Channel Islands and Isle of Man incorporated public companies trading on an multilateral trading facility in the UK, will be subject to the code, regardless of residence of central management and control.

(i) Response Statement on Code amendments for pension scheme trustees

Background

The Code Committee published its consultation paper Pension Scheme Trust Issues (PCP 2012/2) on 5 July 2012 which proposed amendments to the Code relating to certain employee representative rights being extended to apply also to trustees of the offeree company’s pension scheme.

Response Statement

On 22 April 2013, the Code Committee announced its response statement (RS 2012/2) to the consultation paper which subject to certain modifications, approved amendments to the Code to give pension scheme trustees similar rights to those of employee representatives, with effect from 20 May 2013. Key changes include:

(i) a new definition of “Pension Scheme” to limit those schemes in respect of which the offeror must state its intentions in the offer document. The definition defines such schemes as being a funded scheme which is sponsored by the offeree, provides pension benefits, some or all of which are on a defined benefit basis and has trustees (or managers).

(ii) an amendment to new Rule 24.2(a)(iii) to specify that the statement of the offeror’s intentions need relate only to certain specified matters such as employer contributions; accrual of benefits for existing members of the scheme; and the admission of new members to the scheme.

(iii) the decision not to implement the proposed requirements for (a) the offeree board to include in its circular its views on the effect of the offer on the offeree’s pension scheme and (b) disclosure of any agreement between offeror and the trustees relating to future funding (although where the agreement is a material contract, it will still need to be disclosed as such).

(iv) greater access to information. The offeror and offeree will be required to make the same documentation available to the company trustees as they are required to make available to the employee representatives, including the announcement starting the offer period; the offer document; the announcement of a firm intention to make an offer; and the offeree’s board circulars in response to any revised offer document. Trustees will be able to provide the offeree’s company with an opinion on the effect of the offer on the pension scheme. This opinion must either be attached to the circular on the offer to shareholders or published on the website and the publication announced on the RIS.

Following discussions with the UK Pensions Regulator, the Takeover panel has confirmed that there will be no obligation under the Code for the offeror or offeree to send offer-related documentation to the Pensions Regulator, nor will there be any obligation on the Panel to notify the Pensions Regulator of takeover offers. Any decision to seek clearance from the Pensions Regulator will be a matter for the offeror.

The objective of the amendments is to encourage an open debate by ensuring the offeror, the offeree and the offeree’s pension trustees can discuss their views during the early stages of the offer, enabling any issues to be considered by the offeror’s shareholders.

(ii) Companies subject to the Code

Background

The Code Committee published its consultation paper (PCP 2012/3) on the 5 July 2012. The consultation paper proposed:

  • the removal of section 3(a)(ii) of the Introduction to the Code the ‘residency test’
  • the amendment to section 3(a)(ii)(A) and (D) of the Introduction Code known as the ten year rule in relation to certain private companies, including the proposal to apply the Code to private companies that have filed a prospectus for the issue of securities during the ten year period.

The Code automatically applies to companies trading on the regulated markets. The residency test is used to determine whether traded companies on non regulated markets are within the jurisdiction of the Code. If the company has shares admitted to AIM, but the place of central management and control is outside of the UK, the Code will not apply to that company.

The code applies to offers of companies listed on a UK regulated market (i.e. the London Stock Exchange) whose registered offices are in the United Kingdom, the Channel Islands or the Isle of Man (the Relevant Territories).

Response Statement

On 15 May 2013, the Takeover Panel published its response statement (RS 2012/3) following consultation on proposed amendments to the Code for determining which companies are subject to the Code.

The Code Committee supported the proposal that the ‘residency test’ should be abolished for UK, Channel Island and Isle of Man registered companies who have securities admitted to trade on a multilateral trading facility in the UK with effect from 30 September 2013.

However, the Code Committee acknowledged that the ‘residency test’ shall remain for public and private companies which have their registered offices in UK, the Channel Islands and the Isle of Man if it is:

  • a non traded public company
  •  a public company who’s securities are admitted to trading on any market which is not a regulated market (either in the UK or in another EEA member state), an multilateral trading facility in the UK, or a stock exchange in the Channel Isles and Isle of Man
  • A private company who have had securities admitted to trading within the previous 10 years (the ten year rule).

The Code Committee also supported, subject to minor changes, the proposed amendments to section 3(a)(ii)(A) to (D). The amendments will affect private companies by:

  • Simplifying the ten year test; the company must satisfy that the company’s securities have been admitted to trading on a regulated market or a multilateral trading facility in the UK or any stock exchange in the Channels Islands or Isle of Man at any time during the ten year period
  • The company have actually filed a prospectus for the offer, admission to trading or issue of securities (as opposed to the current test of whether a prospectus is required).

Although respondents suggested the time period could also be reduced to five years, perhaps even three years, the Code Committee said this was outside the scope of the consultation.

The Takeover Panel acknowledged that there will not be a need for transitional arrangements or an extended transitional period, the effective date of 30 September 2013 the Takeover Panel believes give companies enough time to remedy any issues arising from the changes. Such companies, who will now become subject to the Code, should review their articles of association to ensure they do not contain conflicting provisions with the Code.

Furthermore, the amendments may now affect shareholders in companies who come to fall within the jurisdiction of the Code. It is important to identify whether a shareholder my trigger a Rule 9 mandatory bid on exercise of convertible securities, warrants or options, in such cases the company should approach the Takeover Panel to seek dispensation from Rule 9.

The views expressed herein are solely those of the author and have not been endorsed, confirmed, or approved by XBMA or any of the editors of XBMA Forum, nor by XBMA’s founders, members, contributors, academic partners, advisory board members, or others. No inference to the contrary should be drawn.

Subscribe to Newsletter

Enter your Email

Preview Newsletter