China

Frequency of M&A disputes

There are no official statistics on the frequency of M&A disputes in mainland China. Nonetheless, the following statistics on disputes relating to equity investment, financial investment or corporate matters, published by major arbitration institutions in China and leading international arbitral institutions in which China-related M&A disputes are most often handled, provide an indication of the frequency of these disputes:

Form of dispute resolution

According to the Annual Report on International Commercial Arbitration in China published by CIETAC,^[15] 259 arbitration commissions in China accepted a total of 400,711 cases in 2020. The number increased to 415,889 cases accepted by 270 Chinese arbitration commissions in 2021.^[16] By comparison, in 2015, domestic Chinese arbitral institutions accepted a total of 136,924 cases.^[17]

Compared with litigation, however, arbitration is overall still less frequently used to resolve disputes in China. The National Judicial Statistics published in the Gazette by the Supreme People’s Court of the People’s Republic of China (SPC) show that national courts at all levels accepted approximately 15.54 million civil cases in 2020 and 19.24 million civil cases in 2021.^[18]

That said, in the authors’ experience, in cross-border M&A transactions where at least one of the parties is non-Chinese, arbitration is more likely to be adopted.

Mediation is another common form of dispute resolution in China. Unlike the practice in many common law jurisdictions, arbitrators in China can also act as mediators in the same case. This is stipulated in the Chinese Arbitration Law.^[19]

Expert determination and other forms of alternative dispute resolution apart from arbitration and mediation are rarely employed in China.

Grounds for M&A arbitrations

The typical grounds giving rise to M&A arbitrations relating to China are summarised below:

Fraud and failure to disclose

M&A agreements in China, like other contracts, are governed by the general provisions of the new Chinese Civil Code (Civil Code), which took effect on 1 January 2021. Pursuant to Articles 148 and 149 of the Civil Code, if one party or a third party, by means of fraud, causes the other party to perform a civil juristic act (e.g., executing an agreement) against its true intentions, the affected party shall be entitled to apply to court or arbitral institution to rescind the act.

According to Article 152 of the Civil Code, this right to rescind a contract is extinguished where the party concerned:

• fails to exercise its right to rescind within one year of the date on which it becomes aware or should have become aware of the cause for recission;
• either expressly or by conduct waives its right to rescind the contract after it becomes aware or should have become aware of the grounds for rescission; or
• fails to exercise its right to rescind within five years of the date of occurrence of the civil juristic act involved.

Article 157 of the Civil Code provides that where a civil juristic act is rescinded, the property acquired as a result of the act shall be returned; if the property cannot be returned or restitution is unnecessary, compensation is due at its estimated price. The party at fault shall compensate the other party for resulting losses. If both parties are at fault, liability shall be apportioned.

Even before or during the conclusion of a contract, one party may be liable for damages if it is found to have (1) engaged in consultation with malicious intent under the guise of concluding a contract, (2) intentionally concealed key facts regarding the conclusion of the contract or provided false information, or (3) committed any other act contrary to the principle of good faith.^[20]

Apart from civil liability, serious fraud can lead to criminal liabilities, including (1) up to 10 years’ or life imprisonment, or (2) fines or confiscation of property.^[21]

There are no specific disclosure standards under Chinese law. Rather, it is mainly an issue of contract drafting; to the extent that parties represent in their agreements that appropriate disclosures have been made but failed to do so, that can give rise to liability.

Burden of proof

Civil Procedure Law (2021 Amendments)

Each party bears the burden of providing evidence for its claims. However, if a party and its representative are unable to collect for objective reasons, or if a court considers the evidence necessary for trying a case, the court will investigate and collect evidence.^[22] Tribunals in China have the power to conduct their own investigation and evidence collection per the Chinese Arbitration Law (Article 43) and arbitral institutions’ rules. However, in practice, this power is not often exercised.

Evidence should be provided in a timely manner. If evidence is provided late, unless the producing party has an acceptable explanation, the court may deem the evidence inadmissible or adopt the evidence but reprimand or fine the party.^[23] Arbitration conducted in China adheres to similar principles.

Standard of proof

The typical standard of proof in civil cases is on the balance of probabilities.^[24] Article 109 of the Interpretation of the SPC on the Application of the Civil Procedure Law (2022 Amendments) raises the standard of proof if fraud is alleged, requiring fraud to be proved beyond a reasonable doubt.

Article 95 of the Provisions of the SPC on Evidence in Civil Proceedings stipulates that where a party concerned refuses, without any justifiable reason, to provide evidence within its control, and a party bearing the burden of proving the fact pending proof alleges that contents of that evidence is disadvantageous to the party in control of the evidence, the court may determine that the allegation is tenable.

Knowledge sharing

We have found no statutory rules on the pooling of knowledge of sellers with management or other representatives of the target.

Remedies

All remedies available under the Civil Code are available to a successful claimant in an M&A arbitration in China. Typical remedies for breach of contract include specific performance, remedial measures such as repair, rework and remuneration reduction, as well as compensation for loss.^[25]

If the performance fails to meet the agreed requirements, and there is no clear agreement in the contract on the remedies available, unless the agreement is supplemented either by parties’ subsequent agreement or in accordance with Article 510 of the Civil Code (which provides that, in the absence of the parties’ subsequent agreement, gaps in agreements shall be determined in accordance with relevant clauses of the contract or based on trade practices), the aggrieved party may, in light of the nature of the subject matter and the degree of loss, reasonably choose to request the other party to repair, substitute or redo the work, return the goods, or reduce the price or remuneration.

Measure of damages

Damages are awarded mainly on a compensatory (rather than punitive) basis.

The amount of compensation shall be equal to that caused by the breach of contract, including the profits receivable upon satisfactory performance of the contract, provided it does not exceed the amount that was foreseen or ought to have been foreseen at the time of conclusion of the contract.^[26]

Liquidated damages

Pre-agreed liquidated damages can be varied by a court or arbitral tribunal. When the liquidated damages are lower than the damage actually incurred, a party may apply to court or arbitral tribunal for an increased sum; when the liquidated damages are significantly higher than the damage actually incurred, a party may apply to make an appropriate reduction.^[27] If the parties agree on liquidated damages for delays in performance, the breaching party remains required to perform its obligations after paying the liquidated damages.

Deposit

Articles 586 and 587 of the Civil Code provide that the parties may agree that one party pay a deposit to the other as a guarantee for its performance. Upon the performance of the obligor’s duties, the deposit shall be offset against the price or refunded to the obligor. If the party paying the deposit fails to perform its obligations under the contract, that party has no right to demand the return of the deposit. If the party that accepts the deposit fails to perform its obligations under the contract, it can be required to refund twice the value of the deposit.

If an agreement provides for both liquidated damages and deposit payment, the non-breaching party may choose to apply either provision.^[28]

Mitigation

Article 591 of the Civil Code provides that when a party has breached the contract, the non-breaching party has to take appropriate measures to mitigate its losses and cannot recover for loss arising from its failure to do so. Reasonable expenses incurred by the mitigating party shall be borne by the breaching party.

Article 592 of the Civil Code provides that if both parties breach the contract, each party shall bear its own respective liabilities under the contract. If one party breaches the contract and causes loss to the other party, but the other party is at fault for the occurrence of the loss, the amount of compensation for loss can be reduced accordingly.

Availability of tort claims

Unless specifically excluded by the arbitration agreement, a claim in tort can be a valid cause of action in arbitration.

Under Chinese law, a claimant is free to choose whether to claim based on contract or tort.^[29]

It should be noted that, even if the claimant is bringing a tort claim that arises from a contractual breach, it remains bound by the arbitration agreement (so long as the arbitration agreement is drafted to cover such disputes). An SPC ruling in September 2020 made clear that parties may not avoid arbitration by tactically choosing tort (over contract) as the cause of action. In the 2020 case, the plaintiff brought an intellectual property infringement suit against a contractual counter­party and a third party as co-defendants. The Shanghai Intellectual Property Court held that the dispute between the plaintiff and the contractual counterparty should be resolved by arbitration as it fell within the scope of a valid arbitration agreement. This was upheld on appeal by the SPC, which noted that even though a third party was joined as co-defendant in the tort claim, the dispute between the parties to the arbitration agreement should still be resolved separately by arbitration.30

Law applicable to tort claims

The applicable law of the contract agreed by the parties may not necessarily be the applicable law governing a claim in tort.

Pursuant to Article 44 of the Law of the People’s Republic of China on Application of Laws to Foreign-Related Civil Relations (i.e., the conflict law in China), liabilities in tort shall be governed by the lex loci delicti, save that where the parties concerned have a common habitual residence, the law of the common habitual residence shall apply. Agreements on the application of law reached by the parties concerned after the occurrence of the tort shall prevail.

Hence, unless otherwise agreed after a tortious activity occurs, a claim in tort shall be governed by lex loci delicti or laws of the common habitual residence. If a tortious activity occurs in China, it is highly likely that Chinese law will apply.

Special substantive issues

For China-related M&A disputes, two substantive issues under Chinese law require special attention: (1) the doctrine of force majeure and change of circumstances, and their interplay with the material adverse change (MAC) provisions that are often key in M&A contracts; and (2) price adjustment mechanisms or valuation adjustment mechanisms (VAMs).

Material adverse change

In M&A contracts, MAC clauses provide buyers with the right to terminate the agreement (a walk away right) if certain defined material adverse changes occur during the execution of the contract and prior to closing of the deal. Therefore, the definition of MAC (or material adverse effect (MAE), a similar concept) is often carefully negotiated between the parties to clarify the risk allocation arising from adverse future developments to the extent possible. Customarily, this definition includes a long list of exclusions, the occurrence of which are defined not to constitute MACs. In many jurisdictions, it is common practice to carve out force majeure events (such as the covid-19 pandemic) from the definition of MAC. This puts the risk of force majeure on the buyer, meaning that the buyer may not walk away from the transaction without liability in reliance on the occurrence of a force majeure event.

Force majeure under Chinese law

That may not be the default case in Chinese M&A agreements. Chinese law^[31] specifically excuses parties from performance of contractual obligations owing to force majeure events occurring, even if the parties have not reached any express force majeure provisions. However, if the parties have reached express agreement as to what does or does not constitute force majeure, usually their agreement will govern rather than the force majeure provisions of the Chinese law. Accordingly, if the parties fail specifically to carve out specified force majeure events from the definition of MAC, the buyer may rely on Chinese law to argue that it has a statutory right to walk away. It is important, therefore, to understand what constitutes a force majeure event under Chinese law.

To qualify as a force majeure event under Chinese law, a party has to prove that the event is objective, unforeseeable, unavoidable and insurmountable.^[32]

The event must be ‘objective’ in the sense that it cannot be a self-inflicted event by the party itself seeking to rely on force majeure. As to the ‘unforseeability’ criterion, the relevant time for the purposes of evaluating foreseeability is the time when the contract is executed.^[33] ‘Unavoidability’ and ‘insurmountability’ require the party relying on force majeure to establish that even if reasonable endeavours were undertaken, the intervening event was so serious that it could not be overcome.^[34]

Chinese law also requires a party relying on force majeure to comply with the notice and proof requirements under Article 590 of the Civil Code. A notification or proof will generally be considered timely if it is made within the period specified in the parties’ contract or, if the contract is silent, within a reasonable time.

If a force majeure event is established, the party who is unable to perform a contract owing to the force majeure event is in part or wholly exempted from liability. Further, if a force majeure event renders it impossible to achieve the purpose of a contract, either party may terminate the contract. If the contract has been performed, a party may, in accordance with the circumstances of performance or the nature of the contract, demand that the other party restore such party to its original state.^[35]

Change of circumstances

In the event a court or tribunal deems the doctrine of force majeure inapplicable, events such as the covid-19 pandemic are likely to trigger the applicability of the Chinese legal regime on change of circumstances.^[36]

To establish a change of circumstance, the following criteria must be met: (1) the purpose of the contract must be shown to be substantially frustrated as a matter of change; (2) the party relying on a change of circumstance must also establish that the change is unforeseeable at the time of the contract, and that it is not a business risk; and (3) the party claiming change of circumstance would also have to show that it will be ‘obviously unfair’ to insist on continued performance of the contract.^[37] Business risks foreseeable by the parties at the time of signing the contract (such as fluctuations in price of shares) do not qualify.^[38]

If a change of circumstances is established, the adversely affected party may renegotiate with the other party. When negotiations fail to resolve the matter, the affected party may request the court or arbitral tribunal to modify or terminate the contract.

Takeaway

The SPC determined in 2020 that covid-19 constitutes a natural disaster for the purposes of Article 117 of the Contract Law (now Article 590 of the Civil Code).^[39] The Shanghai High Court also took the view that the covid-19 pandemic is considered a force majeure event.^[40] Additionally, the China Council for the Promotion of International Trade (CCPIT) has issued covid-19 force majeure certificates to enterprises in China since February 2020.^[41] Although these do not constitute conclusive evidence and do not guarantee a finding by a court or tribunal that covid-19 constitutes a valid force majeure event in any particular case such as to excuse performance, they nevertheless lend support to a buyer in terminating an M&A contract that contains a MAC clause that is silent on force majeure events.

There have been cases in which parties have successfully convinced Chinese courts^[42] or tribunals^[43] that the covid-19 pandemic constituted force majeure or a change of circumstances so that their obligations under the agreed deal were to be excused or varied. Some courts were more conservative in applying that doctrine and rejected the argument, finding that there was no causal connection between the pandemic and non-performance of the obligation.^[44]

Hence, to avoid uncertainty arising from unforeseeable events such as the covid-19 pandemic, parties to China M&A contacts are advised to negotiate and document carefully how the risks associated with unforeseeable events are to be allocated among the parties. Specifically, parties should clearly set out in the MAC definition whether force majeure events are to be included or excluded, as there exist statutory provisions on force majeure (or the somewhat overlapping change of circumstances concept) under Chinese law, which can apply in the absence of express force majeure provisions between the parties.

Valuation adjustment mechanism

VAMs have been widely used in Chinese private equity deals (especially minority investments) during the past decade. VAMs refer to arrangements between an investor and a financing raiser (often the target company or its majority shareholder) when reaching an equity financing agreement to resolve uncertainties about future development of the target company, information asymmetry and agency costs between the parties to the transaction. VAMs provide mechanisms for adjustment to the valuation of the prospective target company, and might be in the form of share repurchase or cash compensation obligations.

A typical example of a VAM would be an exit mechanism (e.g., redemption or put option) guaranteeing the new investor (either by the target company or the existing shareholders) a minimum annual percentage return calculated by reference to its investment amount, with or without a further variable component. The amount might be payable regardless of whether the target is making a profit or suffering a loss, and often the right is triggered if the target company fails to complete a qualified initial public offering within an agreed period upon closing the investment.

VAMs and their legality and enforceability under Chinese law have been frequently disputed before Chinese courts or tribunals during the past decade.

For a time, different courts arrived at different conclusions as to the validity of VAMs under Chinese law. Some courts were of view that a VAM that provides for a guaranteed fixed return is prohibited under Chinese law and thus invalid and unenforceable;^[45] or that a VAM between an investor and the target company is invalid as it is a disguised lending transaction rather than an equity investment and thus could harm other stakeholders’ interests. Other courts have taken the position that a VAM entered into between an investor and the target’s original shareholder (as opposed to between an investor and the target company itself) is not prohibited under Chinese law. This was affirmed by the SPC in 2012 in the influential Haifu case^[46] and its progeny.

The Minutes of the National Courts’ Civil and Commercial Trial Work Conference issued on 8 November 2019 (Jiu Min Ji Yao) provided long-awaited clarity on VAM-related issues. It confirmed that (1) a VAM agreement between a new investor and existing shareholders of the target company is valid, and (2) a VAM agreement between the shareholders and the target company is also valid and the implementation of such an agreement (e.g., allowing a redemption of the investors’ investments) is permitted so long as certain conditions are satisfied. The court or tribunal will consider whether the implementation of a VAM agreement between the shareholders and the target company violates the principle that a shareholder is prohibited from withdrawing its paid-up capital contributions, and the principle that a company may not acquire its own shares unless otherwise permitted by law.^[47]

It is typically advised that the investment return rate in the VAM formulation, if any, should not exceed the upper limit financing cost in private lending transactions. Where the VAM return rate is more than the maximum private loan rate,^[48] a court or arbitral tribunal applying Chinese law is likely to find any return in excess void, effectively lowering the VAM return rate to the maximum private loan rate permitted.

Special procedural issues

Two procedural issues in M&A arbitrations are worth noting: the binding effect of an arbitration agreement on certain non-signatories; and expert appointments.

Binding effect of an arbitration agreement on certain non-signatories

As in many jurisdictions, China adopts the norm that an arbitration agreement only binds signatories. There are a few limited exceptions specifically permitted by Chinese law, including:

• successors to a party after a merger or division;
• heirs to a party after that party’s death;
• insurers who have obtained rights of subrogation, subject to certain limitations; and
• transferees when a creditor’s rights or debts are transferred, unless the parties agree otherwise or the transferee explicitly objects to or is unaware of the existence of a separate arbitration agreement.^[49]

There are also a few situations that are grey areas. Particularly relevant in the M&A context, it is not completely clear under Chinese law whether a non-party can be bound by an arbitration agreement in the following situations and, therefore, a separate analysis is required in each case.

Contract providing performance to a third party

Article 522 of the Civil Code, replacing Article 64 of the Contract Law, provides that where performance of a contract is to a third party, the third party may directly request performance by the obligor and claim breach of contract against the obligor where it is provided by law or by contractual parties’ agreement. It is a welcome change that brings Chinese law in line with most civil and common law jurisdictions that have reformed their rules on privity of contract.

This provision may come into play in M&A deals where parties agree that the buyer, as a post-closing covenant, is responsible for buying directors and officers (D&O) insurance for directors of the target company within a specified period after closing. If the buyer fails to comply with such a covenant, the directors would be entitled to request that the buyer perform that obligation or claim breach against the buyer so long as the contract so provides. In the event that the M&A contract contains an arbitration clause, it would be interesting to see if a director can bring an arbitration against the buyer, or seek to be joined to any existing arbitration between the buyer and the seller. The jury is still out as to how courts and tribunals in China will interpret this provision and whether they will use it to find jurisdiction over third parties who are to receive performance from a contract party.

Piercing the corporate veil

Piercing the corporate veil is not a new legal concept. It can be particularly relevant in the M&A context where, for example, a parent company as a non-party to the acquisition agreement in fact exercises control over the target or subsidiary in the process of signing or performing the agreement. Unlike tribunals in some jurisdictions that have pierced the corporate veil,^[50] courts and tribunals applying Chinese law have been cautious about applying this principle, and there are few publicly reported cases in which a party has successfully used this doctrine to join a non-signatory parent company to an arbitration.

Group of companies doctrine

The ‘group of companies’ doctrine can be traced to the International Chamber of Commerce (ICC) award in the Dow Chemical case.^[51] The ICC tribunal found jurisdiction over a non-signatory to the arbitration agreement, on the basis that it had effectively individually participated in the conclusion, performance and termination of the underlying contract, consistent with the mutual intentions of the parties. The award was upheld by the Paris Court of Appeal.^[52] That said, no official view has been taken by the judiciary on the application of this doctrine in China. Therefore, courts and arbitral tribunals in China are likely to continue to take a prudent approach and conduct their own analysis based on the specific facts and circumstances of each individual case.

Expert appointments

In M&A disputes, expert opinions on accounting issues, industry practice or damage assessment are often necessary. In Chinese M&A arbitrations where such expertise is required, traditionally the tribunal will take the initiative to retain an expert to produce an expert report to assist it. This tradition is evident from, for example, Article 44(1) of the CIETAC Rules, which clarifies that ‘the arbitral tribunal may consult with experts or appoint appraisers to conduct expert appraisals on specialized issues in the case’. This is different from the practice commonly adopted in common law jurisdictions in which each party will retain its own expert (as provided in Article 5 of the International Bar Association’s Rules on the Taking of Evidence in International Arbitration), who will be cross-examined by the opposing side’s counsel, or put in a ‘hot tub’ expert conference with the tribunal leading the questioning.

Notes