Corporate (M&A)
Exercise 3
Due Diligence (3)
(Answer & Tips)
Key Point Checklist
1. Employee Issues
☐ Identify whether statutory end-of-service payment liabilities have been properly reserved for under Hong Kong employment law.
☐ Review ongoing disputes over unpaid overtime claims and assess potential liabilities.
☐ Investigate unresolved Labour Tribunal cases and their potential impact on the transaction.
☐ Request and review template employment contracts to ensure compliance with Hong Kong labor laws.
☐ Check for potential misclassification of workers (e.g., contractors vs. employees) and assess related risks.
☐ Evaluate compliance with mandatory employee benefits, such as pension and medical contributions.
2.Share Option Scheme
☐ Confirm whether formal documentation clearly defines the treatment of vested options during a change of ownership.
☐ Assess the risk of disputes with key employees regarding share options post-acquisition.
☐ Evaluate the alignment of the share option scheme with the Buyer’s post-acquisition plans for employee retention.
☐ Check for tax compliance and potential liabilities associated with the share option scheme.
3. Real Estate Issues
☐ Review expiring lease agreements and confirm whether renewal negotiations have begun.
☐ Investigate the lack of government permits for key warehouses, such as the facility in China.
☐ Verify the permitted use of land and buildings to ensure compliance with zoning and land-use regulations.
☐ Investigate whether any leased or owned properties have unresolved disputes, liens, or encumbrances.
☐ Request title deeds and lease agreements to confirm ownership and lease terms.
☐ Assess the impact of non-compliant facilities on the Target’s operations and valuation.
4. Anti-Corruption Concerns
☐ Identify the absence of a formal anti-corruption policy within the Target.
☐ Investigate reports of regular facilitation payments made to local officials.
☐ Assess potential violations of international anti-bribery laws.
☐ Review internal compliance policies, procedures, and training records to assess the Target’s approach to anti-corruption.
Model Answer
Issues to be spotted:
1. Employee Issues
Concerns:
Statutory End-of-Service Payments: The Target has a large workforce, including long-serving employees entitled to statutory end-of-service payments under Hong Kong law. It is unclear whether adequate provisions have been made for these liabilities.
Unpaid Overtime Disputes: The Target is facing ongoing disputes with employees over unpaid overtime, with some cases currently being handled by the Labour Tribunal. This creates potential financial, legal, and reputational risks for the Buyer.
Significance:
Failure to reserve for end-of-service payments could result in unforeseen liabilities, which will directly impact the valuation of the Target.
Labour disputes, particularly those involving unpaid overtime, may lead to penalties, damage employee morale, and create reputational risks for the Buyer post-acquisition.
Steps to Address:
Request detailed calculations of end-of-service payment liabilities and confirm that sufficient reserves have been made in the Target’s accounts.
Review Labour Tribunal cases to assess the likelihood of adverse rulings and quantify potential financial exposure.
Conduct a legal review of the Target’s employment contracts to ensure compliance with Hong Kong labor laws, particularly regarding overtime arrangements.
2. Share Option Scheme
Concerns:
The documentation for the Target’s share option scheme is poorly structured, with ambiguous terms regarding the treatment of vested options in the event of a change of ownership.
This creates the risk of disputes with key employees post-acquisition, which may undermine employee retention and jeopardize the Buyer’s business plan.
Significance:
Ambiguities in the share option scheme could lead to legal disputes, financial claims, or key employees leaving the company, potentially affecting the Target's operations and valuation.
Steps to Address:
Engage legal counsel to review and clarify the terms of the share option scheme, particularly with respect to the treatment of vested options.
Consider negotiating amendments to the scheme to align it with the Buyer’s post-acquisition retention strategy.
Ensure that the Target’s employees are informed and supportive of any changes to the share option scheme.
3. Real Estate Issues
Concerns:
Several lease agreements for critical warehouses and offices are close to expiration, and no renewal negotiations have commenced.
One of the Target’s key warehouses in China is operating without the proper government permits.
Significance:
Expiring leases pose a risk to the continuity of operations, especially if renewal negotiations fail or result in unfavorable terms.
Operating without the proper permits exposes the Target to regulatory enforcement actions, fines, or even facility closures, which would disrupt operations.
Steps to Address:
Request an updated schedule of lease agreements, including expiration dates and renewal terms, and confirm whether renewal discussions are underway.
Engage local counsel to investigate the permitting issues for the warehouse in China and assess the steps required to obtain compliance.
Evaluate the financial impact of potential fines or operational disruptions due to non-compliance.
4. Anti-Corruption Concerns
Concerns:
The Target has no formal anti-corruption policy in place.
Management confirmed that “facilitation payments” are regularly made to local officials in certain jurisdictions to expedite customs clearances. This raises concerns about potential violations of the UK Bribery Act and the US Foreign Corrupt Practices Act (FCPA).
Significance:
Facilitation payments may constitute violations of anti-corruption laws, exposing the Buyer to significant legal, financial, and reputational risks post-acquisition.
The lack of a formal anti-corruption policy suggests weak compliance practices, which could lead to further exposure in other areas.
Steps to Address:
Conduct a forensic review of the Target’s payment practices to identify and quantify potential exposure to anti-corruption violations.
Engage compliance experts to assess the Target’s risk exposure under the UK Bribery Act, FCPA, and other applicable laws.
Require the implementation of a robust anti-corruption policy as a condition of the transaction to mitigate future risks.
5. Compliance and Operational Risks
Concerns:
The Target’s overall compliance practices appear weak, as evidenced by the lack of formal anti-corruption policies and permitting issues for key facilities.
There may be additional undisclosed compliance risks, particularly in jurisdictions with complex regulatory environments.
Significance:
Non-compliance with local laws and regulations could result in fines, penalties, or operational disruptions, all of which would negatively impact the Target’s valuation and the Buyer’s post-acquisition plans.
Steps to Address:
Conduct a detailed compliance audit of the Target’s operations to identify any additional regulatory risks.
Engage local counsel in each jurisdiction to confirm compliance with labor, tax, environmental, and operational regulations.
Ensure that all necessary licenses and permits are in place before completing the transaction.
Common Mistakes
Overlooking critical risks such as the lack of formal anti-corruption policies, ambiguous share option scheme documentation, and permit issues for the warehouse in China.
Treating issues in isolation without recognizing how they interconnect, such as compliance risks impacting valuation and operations.
Focusing on minor or generic risks while ignoring deal-specific issues like expiring leases or employee liabilities.
Simply listing issues without explaining their legal or financial significance, such as failing to connect statutory end-of-service payments to potential liabilities.
Misinterpreting laws like the UK Bribery Act or FCPA, or failing to recognize their extraterritorial application to the Buyer.
Overlooking jurisdictional variations, such as Hong Kong labor laws versus compliance requirements in China or other Asian jurisdictions.
Failing to consider the operational impact of issues like expiring leases or non-compliant facilities, such as warehouse closures disrupting supply chains.
Not addressing how disputes over share options could affect employee retention and morale, which are critical to the Target’s continued success.
Focusing solely on legal risks without considering reputational or commercial risks, such as facilitation payments damaging the Buyer’s reputation.
Providing vague or generic solutions, such as “review the issue further,” without outlining actionable steps like compliance audits or renegotiating share option terms.
Forgetting to tailor recommendations to the Buyer’s priorities, such as mitigating risks to protect valuation or ensuring operational continuity post-acquisition.
Failing to quantify financial exposure from unresolved labor disputes, statutory payments, or non-compliance fines.
Professional Tips
Please see professional tip on due diligence in M&A exercise 1.