Focus on: China M&A Series – Managing Contingent Liabilities in the M&A Context

Introduction

An in-depth and precise understanding of the target’s assets and liabilities is crucial for the buyer in mergers and acquisitions transactions. Defects of the target’s assets and the scope of the target’s liabilities will directly affect the buyer’s valuation assessment of the target and the various terms of the Share Purchase Agreement (the “SPA”), such as condition precedents, payment mechanisms and representations and warranties. Generally, a buyer can gain a relatively comprehensive, quantitative understanding of the target’s assets and liabilities through the target’s financial statements and independent financial due diligence, which will enable the buyer to build financial models and perform valuation assessments. However, beyond the data presented in the financial statements, there are numerous facts and risks that cannot be confirmed, measured and presented in the financial statements. These uncertainties can substantially impact the target’s future assets and liabilities and must be addressed in the SPA.

Contingent liabilities are a typical form of uncertainty that cannot be directly quantified and included in the financial statements. This article explores how to properly address the impact of these uncertainties on the target’s value and transaction structure through the terms of the SPA, focusing on contingent liabilities in M&A transactions.

 

1. What Are Contingent Liabilities?

“Contingent liabilities” refers to: (1) potential obligations arising from past transactions or events, whose existence is contingent upon the occurrence or non-occurrence of one or more uncertain future events; or (2) current obligations that have arisen from past transactions or events, where it is unlikely that an outflow of economic interests will be required for settlement or where the amount of the obligation cannot be reliably measured.[1] Due to these characteristics, contingent liabilities do not meet the criteria or standards for recognition as liabilities under current Chinese accounting standards, and thus cannot be quantified or recorded in a balance sheet. Typically, accountants exercise their professional judgment to assess the likelihood of a contingent liability materializing into an actual obligation and the potential magnitude of losses, and selectively disclose such liabilities in the notes to the financial statements.[2]

From an accounting perspective, typical contingent liabilities include:

• Guarantees provided for third-party debts;
• Pending litigation and arbitration;
• Product quality and safety guarantees;
• Responsibilities related to environmental protection laws;
• Potential liabilities for taxes and social insurance contributions.

In merger and acquisition (M&A) transactions, the scope of “contingent liabilities” in an M&A lawyer’s mind may be broader than the accounting definition, encompassing a wider range of potential defects and risks, such as:

• Breaches or potential disputes not yet under litigation or arbitration;
• Non-compliance not yet noticed or addressed by regulatory authorities;
• Potential intellectual property infringements (even if such infringement cannot be fully confirmed based on known facts);
• Preferential Policies or rebates received by the target that may be forfeited due to failure to continuously meet its commitments to the government or due to uncertainties in the preferential policies;
• Important qualifications that may fail to be renewed or might be revoked;
• Key equipment or fixed assets that may become unusable before the end of their amortization period for special reasons;
• Contracts that may be terminated before expiration of their terms by major customers;
• Supply prices that may be foreseeably raised by suppliers

 

These defects and risks represent negative contingencies that should be identified and assessed during due diligence and appropriately addressed in the transaction documents.

For M&A lawyers, contingent liabilities, similar to various defects discovered during due diligence, must be thoroughly communicated, understood, and assessed with the buyer. A particular distinction is that if a matter is deemed a contingent liability from an accounting perspective, its adverse impact will not be reflected in the financial statement figures and thus is likely not be factored into the initial valuation assessment. If a contingent liability is not reflected and addressed in the pricing mechanism or in the transaction documents, once it materializes into a definite and quantifiable liability borne by the target in the future, the buyer will ultimately bear the losses resulting from such contingent liability, as these losses were not adequately considered in the valuation assessment. Given this, when a contingent liability is recognized in the footnotes of the target’s financial statements from an accounting perspective, M&A lawyers should be particularly vigilant in structuring the SPA terms to ensure that these risks are fully considered and assessed during transaction negotiations and adequately reflected in the SPA terms.

 

2. Identifying the Contingent Liabilities of the Target in M&A Transactions

In M&A transactions, the target’s contingent liabilities can be identified and assessed through the following channels:

2.1 Financial Statements

In M&A transactions, the seller typically provides the most recent financial statements of the target as part of the diligence materials. The most direct way to identify contingent liabilities is through these financial statements.

According to current Chinese accounting standards, a company should not recognize contingent liabilities but must disclose them in the notes to the financial statements, except for those extremely unlikely to cause an outflow of economic interests.[3] The specific information to be disclosed should include: (1) the type and cause of such contingent liabilities, including those arising from discounted commercial acceptance bills, pending litigation, pending arbitration, and guarantees provided to third parties; (2) an explanation of the uncertainties related to the outflow of economic interests; (3) the estimated financial impact of the contingent liabilities and the possibility of compensation; if the estimate cannot be made, the reasons thereof should be explained. Accordingly, if an accountant determines that a particular risk of the target qualifies as a contingent liability under accounting standards, it should be disclosed in the financial statement notes unless it is extremely unlikely to cause an economic outflow.

As mentioned above, whether potential liabilities or risks are disclosed in the financial statements as “contingent liabilities” largely depends on the accountant’s judgment of the “probability.” When a potential liability or risk is highly probable, it may be recorded directly as “provision for liabilities” on the balance sheet. Current Chinese accounting standards stipulate that an obligation related to a contingent event qualifies as provision for liabilities if it meets the following criteria: (1) the obligation is a present obligation of the company; (2) it is probable that an outflow of economic interests will be required to settle the obligation[4]; and (3) the amount of the obligation can be measured reliably. Similar to contingent liabilities, provision for liabilities require disclosure in the notes to the financial statements as well. However, unlike contingent liabilities, provision for liabilities are recognized and measured, then quantified and included directly on the balance sheet (meanwhile, the income statement will also be impacted). The separate disclosure of provision for liabilities in the notes serves primarily to enhance the comprehensibility of the financial statements. Although provision for liabilities can be quantified and measured, their amounts are based on the company’s best estimate, fully considering relevant risks and uncertainties. As time and circumstances change, the provision for liabilities recognized in the balance sheet may change or result in unforeseeable outcomes. Due to this uncertainty, transaction lawyers should also pay attention to the provision for liabilities disclosed in the notes to the financial statements.

Additionally, it is worth noting that the accountant’s determination of whether a risk constitutes a contingent liability (or provision for liabilities) and whether it needs to be included in the notes to the financial statements (based on an assessment of the likelihood of the obligation being realized) is influenced by the facts provided by the target’s management and their assessment of the likelihood and measurement of losses. The assessment by the target and its accountants may not align with that of the buyer and the buyer’s advisors, and therefore, the buyer cannot solely rely on the target’s accountants for the treatment of contingent liabilities and provision for liabilities in the financial statements.

2.2 Due Diligence

In addition to reviewing the financial statements provided by the target, buyers in M&A transactions typically conduct comprehensive due diligence on the target from financial, legal, business, and other perspectives, utilizing in-house teams or external professionals. This process covers various aspects of the target, each of which may reveal contingent liabilities or other adverse contingencies.

During financial due diligence, the buyer’s accountants generally focus on contingent events involving the target. If contingent liabilities exist, they will be presented in the financial due diligence reports. While such reports may not have a dedicated section on contingent liabilities, relevant alerts may be scattered under sections such as “Compliance Risks,” “Litigation,” “Tax Risks,” and “Mortgages and Guarantees,” which should be thoroughly considered and comprehended by transaction lawyers. Moreover, legal due diligence can reveal numerous defects and risks of a contingent liability nature, including significant pending litigation or arbitration, guarantees provided for third parties, potential responsibilities related to social insurance and housing fund, and potential infringements or contractual liabilities. Some of these findings may overlap with those discovered during financial due diligence, while others may not strictly fall under the accounting concept of contingent liabilities but should be treated similarly in transactions. Business due diligence may also reveal situations related to contingent liabilities. For example, interviews conducted during business due diligence might disclose disputes between the target and certain key customers, with one party potentially planning to terminate the contract early. In summary, transaction lawyers must integrate the findings from financial, legal, and business due diligence to adequately identify the scope of contingent liabilities and address them appropriately in the transaction documents.

2.3 Representations and Warranties; Disclosure Schedule

Due to the inherent information asymmetry between the buyer and the seller, compounded by frequent time constraints on and incompleteness of information provided during M&A due diligence, buyers often request for comprehensive representations and warranties from the seller and the target in the SPA, compelling them to proactively disclose known risks and defects. On the other hand, the seller can mitigate its liability under the representations and warranties clauses by proactively disclosing and shifting the risks back to the buyer. Given the fact that contingent liabilities are often hidden and events or facts giving rise to contingent liabilities are generally difficult to uncovered through public channels, discovery of such facts is heavily dependent on proactive disclosure by the seller or the target. Therefore, including provisions related to contingent liabilities in the representations and warranties becomes particularly important.

Specifically, buyers often require the seller and the target to make representations and warranties in the SPA that, except for information explicitly disclosed in the target’s financial statements and the disclosure schedule, there are no other material liabilities, debts, or obligations of any type (whether existing or contingent). Given the broad definition of contingent liabilities, sellers may hesitate to provide such representations and warranties, concerning about differing interpretations and assessments of contingent liabilities or the existence of contingent liabilities unknown even to the seller itself. In such cases, sellers may request that the representations and warranties regarding contingent liabilities be limited to their knowledge. The concept of “Knowledge” can be further divided into “actual knowledge” and “constructive knowledge,” with specific interpretations to be clarified in negotiations between the buyer and the seller. The parties may also agree on monetary thresholds for “material” liabilities or specify the types of liabilities to be included.

Additionally, considering that the scope of contingent liability representations and warranties is subject to subsequent negotiations and therefore uncertain, the buyer should also seek to obtain as much protection as possible from other related representations and warranties, such as those regarding the normal use of production equipment, non-infringement of intellectual property, absence of significant disputes, and legal compliance. The more comprehensive these representations and warranties are, the more likely the buyer will be contractually protected and remedied if undisclosed contingent events materialize into actual obligations.

Based on these representations and warranties, the target and the seller should disclose known contingent liabilities in the disclosure schedule. Transaction lawyers should cross-check the disclosure schedule with the due diligence findings and make dynamic adjustments to the transaction documents.

 

3. Handling Contingent Liabilities in Transaction Documents

3.1 Pre-Transaction Resolution

If a contingent liability is particularly significant and could potentially influence the buyer’s investment decision, the buyer may require the seller and the target to resolve the issue either prior to the signing of the SPA or the closing of the transaction, thereby converting the contingent liability into a definite, reliably measurable provision.

For instance, while negotiating the M&A transaction, the target may be involved in a substantial arbitration due to a breach of contract or a litigation involving the ownership of core intellectual property, with long-lasting proceedings and unpredictable outcomes. If the buyer determines that the outcome of such litigation or arbitration could significantly impact its investment decision, it may request that the target conclusively resolve these matters before the closing. This typically means that the target will need to reach a settlement with the opposing party before the long-stop date of the merger. In such cases, to expedite the settlement, the target may inevitably need to make certain compromises and concessions that, from the seller’s and company���s perspective, could be less favorable than resolving the dispute through regular legal procedures. This would be considered a suboptimal solution to meet the buyer’s demands to facilitate the M&A transaction. Should a settlement be reached, but the target’s losses exceed the original commercial expectations, determining who should bear these losses in excess and whether the buyer has the right to adjust the purchase price accordingly would need to be addressed in the commercial negotiations and in transaction documents.

3.2 Deferred Payment of a Portion of the Consideration

If a contingent liability is significant but cannot be resolved before the closing due to various practical reasons, the buyer may choose to withhold a portion of the consideration at the closing. Once the contingent liability is definitively resolved after the closing, the withheld payment (the “Holdback”) will then be handled based on the confirmed liability at that time. Essentially, this Holdback mechanism functions as a form of “price adjustment.” Specifically, if the confirmed liability is less than the Holdback, the buyer should pay the seller the difference between the Holdback and the confirmed liability. If the confirmed liability exceeds the Holdback, the buyer would not need to pay the Holdback to the seller and may, depending on the terms of the transaction documents, even seek further compensation from the seller. Additionally, the Holdback mechanism involves negotiating various detailed, including but not limited to:

• Holdback Amount: When a contingent liability has a defined maximum potential loss—such as the maximum exposure under a third-party guarantee—this figure often forms the basis for negotiations regarding the Holdback amount. The final agreed amount depends on several factors such as the nature of the contingent liability, the likelihood of it materializing into an actual obligation, and the relative bargaining power of the buyer and seller, requiring thorough evaluation by transaction lawyers in collaboration with clients and accountants.
• Holdback Period: Typically, unless the buyer possesses significantly strong bargaining power in the transaction, the seller—motivated to receive the full purchase price as quickly as possible—will typically seek to limit the duration of the Holdback period. If the Holdback period expires without the contingent liability being resolved, the buyer is generally required to release the Holdback to the seller. In such cases, transaction lawyers need to propose an appropriate timeframe depending on the nature of the contingent liability (for instance, timelines of customary litigation procedures) and devise a mechanism for handling the contingent liability after the Holdback period.
• Holdback Escrow: To balance the risks and monitor the handling of the Holdback between them, the parties may choose to place the Holdback in a regulated escrow account. The parties may also agree on how to handle the interest generated from the Holdback (typically deposit interest).

In summary, Holdback arrangements are closely tied to the specific details of contingent liabilities. Transaction lawyers must thoroughly understand the details of these liabilities, including whether they are quantifiable, the timeline for its resolution, and the likelihood of materializing into actual liabilities, and to design the Holdback mechanism rooted in thorough communication with clients.

3.3 Special Indemnity Clauses

Not all contingent liabilities, once they materialize into actual obligations, can be quantified. For instance, issues such as license revocation or intellectual property defects, aside from current administrative penalties or infringement compensation, can significantly affect the target’s ongoing operations and future development, potentially leading to a substantial devaluation or forced adjustments to its business model. The adverse effects from these issues might not be readily resolved by withholding a portion of the consideration or through price adjustments.

Moreover, certain types of contingent liabilities present substantial unpredictability regarding whether they will or will not materialize or be converted into actual obligations. In such cases, the seller may not agree to a Holdback, as it implies prolonged deferment of payment (unless a shorter term is set for the Holdback).

For liabilities that impact company value but cannot currently be tackled through price adjustments or Holdback mechanisms, the parties will typically negotiate a set of special indemnity clauses. These clauses stipulate that if a contingent liability subsequently materializes and causes losses to the buyer, the seller shall indemnity the buyer for such losses. Special indemnity clauses often contain detailed specifications and limitations, such as minimum thresholds for claims, caps on indemnity amounts, definitions of indemnifiable losses, and the buyer’s obligation to mitigate losses in good faith. All such terms must be clearly articulated in the Share Purchase Agreement (SPA).

However, it is worth noting that in practice, the effectiveness of special indemnity clauses may be limited by practical considerations during the transaction. For instance, if the acquisition involves a cross-border deal where the buyer and the seller are from different jurisdictions, the enforcement of such special indemnity clauses may involve complex cross-border claims, making the process more complex and the recovery amounts less certain. Conversely, if the seller retains a stake in the target or appoints individuals to remain in management positions after the closing, there may be greater flexibility in negotiating claims under the special indemnity clauses.

 

3.4 Representations and Warranties and General Indemnity Clauses

Whether resolving contingent liabilities before the transaction or addressing them through a Holdback mechanism or special indemnity clauses, these mechanisms largely depend on the seller’s proactive disclosure of the contingent liabilities and relevant materials to the buyer. If the seller conceals or omits contingent liabilities, leading to undisclosed defects that the buyer was unaware of prior to signing the SPA, the buyer may still be protected through representations, warranties, and general indemnity clauses. Based on these representations and warranties related to contingent liabilities in the SPA, if the buyer discovers post-closing any undisclosed contingent liabilities occurring pre-closing, the seller would be in breach of the representations and warranties clauses and would be liable for damages to the buyer.

It should also be noted that, in practice, the protection under representations and warranties has limitations depending on specific terms under transaction documents: (1) Firstly, representations and warranties do not extend to material risks disclosed by the seller in the disclosure schedule; (2) Some strong sellers may insist in transaction documents that the buyer cannot assert a breach of representations and warranties based on information known before closing, regardless of whether it appears in the disclosure schedule; (3) Even if agreed upon in the transaction documents that the buyer’s prior knowledge of relevant information does not affect claiming a breach post-closing, the enforceability of such clauses in Chinese judicial practice remains questionable and subject to further case validation; (4) Additionally, claims under representations and warranties are typically subject to set deadlines (e.g., 18 months after closing) in the transaction documents, beyond which the buyer cannot claim indemnity for defects emerging later.

 

4. Conclusion

Contingent liabilities, due to their inherent uncertainty, pose significant risks in M&A transactions. Addressing these liabilities adequately and comprehensively in transaction documents is a critical responsibility for transaction lawyers, who must carefully consider the specific circumstances of the deal. From the buyer’s perspective, the key lies in conducting thorough due diligence to identify contingent liabilities of the target. Then, through discussions with the buyer’s accountants, the target, and its advisors, the transaction lawyer must clarify the relevant facts to the greatest extent possible, assess the likelihood and maximum potential loss, and facilitate the buyer in evaluating the actual risks posed by the contingent liabilities. Based on this analysis, transaction lawyers should advise on risk management strategies and help negotiate trade-offs during the M&A transaction to ensure that the buyer receives robust and practicable protections, so that contingent liabilities, which may not be directly accounted for in financial statements, are properly factored into buyer expectations and adequately reflected in transaction documents.

 

Authored by Jackson Tang ([email protected]), Partner at Haiwen & Partners

 

Footnotes:

[1] PRC Corporate Accounting Standards No. 13 (Contingencies), Article 13, Clause 2.

[2] It is worth noting that not all contingent liabilities are necessarily disclosed in the notes to financial statements. The disclosure of contingent liabilities ultimately depends on the accountant’s judgment based on the facts; therefore, one cannot solely rely on those notes to determine whether the target has contingent liabilities.

[3] The probability range for “extremely unlikely” is greater than 0 but no more than 5%.

[4] The probability range for “highly probable” is greater than 50% but no more than 95%.