Trapped in acquisition of Chinese private company
Trapped in acquisition ofChinese private company
Written by William Wang
One day in April 2008, in anexecutive room of Marriot Hotel of Pudong Shanghai, one Dutch guy Luca wasexhausted lying in bed, watching the court summons on the desk.
All thesetroubles come from a Chinese man: luca’sbest friend, his business partner with 20 years’ cooperation: Liang Cao; fromwhom luca acquired a manufacturing company, which was 100% owned by Liang’sfamily.
Get to know the Chinese market
During 1980s, China was alittle known market, Deng Xiaoping's reform and opening policy had juststarted, China was just beginning to open the door to the foreign investors.
In the year of 1984, Luca wentto Macau, where he met a lot of Chinese businessmen; form them Luca was awareof the ongoing Guangzhou Trade fair. Luca went to the fair and found Chineseproducts were extremely cheap. What most interested him in the exhibition wereleather products, such as wallets, handbags, luggage, shoes, etc. Having hadleather business in European market before, Luca knew, the price listed inGuangzhou would be sold at as 10 times as much in Europe.
Luca met a young guy at onebooth of Shanghai Import and Export Corporation, Liang Cao, who worked for the company'sleather products department, responsible for the European market. They negotiatedthe price, discussed the quality, and had dinner together. Luca promised toLiang that he would place an order of one container to have a test. Liang wasvery happy to fix up a European customer. Since then, Luca found a new goldmine- China.
Get to know international VCPE capital
During 1990s, Luca and Lianghad continued the cooperation. Liang had ever changed the job twice, howeverLuca still placed all orders to him, regardless where Liang worked; this showedLuca’s consistent trust and confidence on Liang.
The demand of European marketfor Chinese leather products had been increasing, Chinese products were sold atlow prices, while quality was acceptable. Business went on very well, Luca madea great amount of profits from the deals with Liang. From the year of 2001 Lucaaveragely ordered 100 containers every month from Liang.
Chinese import and exportcompanies were on the way of restructuring at end of last century. Liang tookthe advantage of accumulated customers and established his own company:Shanghai Hejia Leather Co., Ltd., its main business was to produce and exportleather products.
It had one big customer- Luca.
Since the beginning of 21stcentury, many international VC PE capitals are crazy about China concept. Sina,Ctrip, Alibaba, Baidu, etc all reflects that international funds are excellent atcapital operation; they invest in Chinese companies and make them listed inoversea stock exchange markets, and consequently sell out their equityinvestment. Under this background, in 2006 Luca met in the Netherlands hiscountrymen: John and Hans.
Careful design of beingbillionaire
Johnand Hans have ashining background. Both graduated from Harvard Business School, got MBAdegree. After Harvard, they worked at Wall Street, Goldman Sachs and MerrillLynch respectively. Years later they were sent to London. Although theirsalaries were high, John and Hans were not interested to be an employee; they leftGoldman Sachs and Merrill Lynch, founded a partnership business-JH Capital,using their own funds to invest in promising European small and medium-sizedfirms, and to participate in the management, and ultimately to sell their sharesto other VC and PE.
In 2006they met Luca. Luca boasted to John and Hans of his experience in China,and the huge profits he made from China. At that time John and Hans did notknow China too much, after hearing the story of Luca,they realized that it might exist business opportunity.
John and Hans directly askedwhether Luca had his own company in China, whether he was willing to transferpart of his shareholding. Luca boasted that he had a wholly-owned company withits monthly export to the world of 200 containers; sales had been increasedsteadily over the past years and would be increased without any doubt for theyears to come.
The wishful thinking of John and Hans is that with their experience in capital markets, and with Chinaconcept, they can put Luca’s company to be listed in London, Frankfurt or NewYork stock exchanges. After successful listing they could sell out all theirshares in the open market, to get a high return of the investment.
Luca, John and Hans hadultimately agreed that John and Hans would pay USD9 million to acquire 50% of stakeof Luca’s company in China; John would be Chairman of the Board, Luca, John andHans would be all together involved in the management. After this transaction,Luca hurried back to Shanghai China to design his road to billionaire.
First of all Luca set up a100% self owned company in Shanghai: Dechuang Leather (Shanghai) Co., Ltd.;which will acquire the company of his Chinese friend Liangcao: Shanghai HejiaLeather Co.,Ltd.; next step Luca went to Hong Kong, where he would incorporate anew firm called Dechuang Leather (Hong Kong) Co., Ltd., he would put the assetsof Dechuang (Shanghai) into Dechuang (Hongkong) ; afterwards, according to theagreement between Luca and JH Capital, they all together would establish acompany called Dechang (BVI) Co.,Ltd in the British Virgin Islands, thiscompany will be the subject company to be listed in the stock exchange market.
Trapped in the quagmire
Lucaand his Chinesefriend Liangcao negotiated the takeover deal and finally entered into anM&A contract. Luca would pay RMB18 million to purchase all assets ofLiangcao’s company (the price was high valued because the book value of thecompany was worth of RMB15 million). After the takeover, Dechuang (Shanghai) Co.,Ltd. and Shanghai Hejia Co. Ltd are independent of each other, and thecompany's debt is independent as well.
Because Luca and Liangcao hada perfect cooperation for many years, Luca had high trust in Liangcaopersonally, and therefore entrusted him to carry out the whole takeoverprocedure, including transfer of all physical assets and legal documents.
Who would have thought that atthat moment Luca’s Chinese partner was digging a trap for him.
After Liangcao sold all theassets of Shanghai Hejia to Luca, he immediately formed a new private company --ZhejiangWanjia Leather Co.,Ltd. and secretly moved high quality assets of ShanghaiHejia to Zhejiang Wanjia including raw materials, semi-finished and finishedproducts; which had actually been sold to Dechuang (Shanghai) already, legalownership does not belong to Shanghai Hejia and Liangcao himself; Dechuang(Shanghai) was the real owner.
At the same time Liangcaoordered his long-term supplier-Fanzhou leather products factory to sendsemi-finished product to his warehouse, however with consignee in the receiptmarked with “Dechuang (Shanghai)," and he ordered the warehousesupervisor, previous an employee of Shanghai Hejia, now transferred to Dechuang(Shanghai) signed on the receipt on behalf of Dechuang (Shanghai). HoweverDechuang(Shanghai) did not even commence its business at the time. These newsemi-finished products had eventually been moved to the warehouse of ZhejiangWanjia Co., the newly established company by Liangcao. Legal consequence wasDechuang (Shanghai) had to bear the liability and it actually did not receivethe goods. This situation lasted about six months.
Luca gradually discovered the secret, he cancelled the delegation to Liangcao and replacedall management staff of Dechuang (Shanghai), in an attempt to create anultimate control over Dechuang (Shanghai).
But when Luca appointed anaccounting firm to audit on what he purchased from Shanghai Hejia, hesurprisingly found that the assets he bought from Liangcao were mostly useless,for example out of date finished products and raw materials. Luca reachedLiangcao and discussed the issue with him. One day Liangcao disappeared. Lucabecame extremely nervous, and after serious consideration, he decided to bringsuit against Liangcao.
March of 2008, Liangcaodisappeared and Luca failed to connect him for a period. Luca finally brought asuit against Liangcao to request the repudiation of acquisition contract, remediesfor the loss occurred in the transaction. Originally Luca was full of confidenceto win the case; however he and Dechuang (Shanghai) were receiving a courtsummons as well, with its bank accounts frozen.Fanzhou leather products factory sued Dechuang (Shanghai) for breach ofcontract, requiring Dechuang (Shanghai)to pay nearly 6 million of debts due.According to the plaintiff's request, the Court seized all bank accounts of Dechuang (Shanghai).
At the same time thoseemployees who were previously employed by Shanghai Hejia and consequentlyemployed by Dechuang (Shanghai) and finally dismissed by Luca, collectivelytook action against Dechuang (Shanghai) and asked for a court order thatDechuang should pay them damages. On the other hand because bank accounts werefrozen, Dechuang (Shanghai) could not pay to suppliers and landlord on time,they all brought suits against Dechuang (Shanghai) simultaneously.
Overnight, the whole situationbecame a mess.
John and Hans heardabout the situation and immediately came to China, and found that they had beendeceived. John and Hans returned to the Netherlands, took the case to thecourt, accusing Luca of suspected fraud in share transfer deal, demanding thetransfer being void, and return of money and pay damages for losses.
Until the year of 2010, Luca is still trapped in these proceedings and not free from them. TheChinese adventure taught a big lesson.
How to deal with risk inM&A of Chinese private enterprises
Conduct in-depth duediligence.
Whenever a major transactiontakes place, you should let the professional lawyers to get involved, to investigatethe targeted enterprise and majority shareholder and actual controller andshadow shareholders if any. The purpose of legal due diligence is to reducepotential legal risk.
As per this case, althoughLuca had been cooperating with his Chinese friend Liangcao for almost 20 years,legal due diligence is still indispensable.
Chinese entrepreneurs alwayshave such believe that their personal properties belong to the company, and thecompany's properties are also theirs; they often misappropriate, embezzle company’sassets. It not only infringes Company Law but commit a criminal offence. Lucaneglected in-depth due diligence and consequently paid high price. Legal duediligence is aimed to avoid risks, preventing problems.
Once problems, disputes oreven litigation occurs, company and its owner will take more time and effort to cope withthe issue which greatly affect normalbusiness operation.
Review the contracts with fullof care and work with vendors to sign new agreement.
The acquired company's vendorsare resources. Usually the company takes a very long time to cultivate aqualified supplier; Through M&A the acquirer can easily take over thosesuppliers.
However, the acquirer must reviewand inspect the previous contracts very carefully, and to sign a new contract withthe suppliers setting renewed provisions, because the suppliers are closely connectedwith acquiree. The acquired’s suppliers areresource, they are also potential risk. As per this case Dechuang (Shanghai),Luca and his managers simply neglected to inspect the previous contracts signedby the acquiree company Shanghai Hejia and suffered huge loss.
Avoid unconditionallyaccepting previous employees of acquiree company.
Similarly, those staff fromacquiree company are both resource and risk, the degree of risk is much higherthan that of the supplier. The boss had the special relationship with the keyemployees in private firm, which is an indisputable fact. As per this case, warehousesupervisor is a key staff, and Liangcao had definitely the hidden relationshipwith him. They colluded to defraud the acquirer company in order to transferliability and debts in legitimate form.