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In recent M&A cases, financial investors have increasingly faced civil liability or criminal prosecution due to fraud committed by target companies. These cases highlight a growing tension: although such investors typically do not involve themselves in day-to-day operations, they can still be held legally accountable for the fraudulent acts of other parties. This shift stems largely from stricter judicial interpretations of financial investors¡¯ duty of care, as well as the fact that ¡°independence clauses¡± in transaction documents often fail to withstand substantive legal review.

Root causes

Legal standpoint. Article 149 of China¡¯s Civil Code stipulates that a financial investor can be held jointly liable as an accomplice to third-party fraud if the seller (e.g. a controlling shareholder) committed fraud and the investor ¡°should have known¡± about it. In practice, courts often dismiss defences based on the investor¡¯s independence by examining two key aspects.

The first one is the transactional linkage. Although financial investors may not lead negotiations, their status as a co-seller and their act of signing the agreement are construed as an endorsement of the entire transaction. In the case Xin Min Zhong No. 120 (2023), for instance, the court ruled that the letter of commitment signed by all shareholders constituted implied consent to the fraudulent activity.

Another factor is the ease of information access. Once a financial investor takes actions such as appointing a director or reviewing financial reports, they are presumed to have had a reasonable capability to detect fraud. In the case of Zhe Min Zhong No. 171 (2021), the court ruled that the investor should have been aware of the fraud, citing its failure to investigate thoroughly after having previously identified historical accounting issues.

Transaction documents. The ¡°representations and warranties¡± and ¡°joint liability clauses¡± commonly found in M&A agreements form the primary legal basis for holding financial investors accountable. Broadly worded guarantees, such as a seller¡¯s promise that the disclosed information is ¡°true and complete¡±, can be interpreted as applying to the entire transaction, including false material provided by other sellers. As for joint liability clauses, even if they state that ¡°each seller is liable independently¡±, courts may still impose joint liability based on a finding of collective fraud.

Burden of proof. While the principle of ¡°he who asserts must prove¡± requires the acquirer to demonstrate that the financial investor ¡°knew or should have known¡± of the fraud, the practical reality is often different. Lacking access to primary financial data, investors struggle to refute audit reports submitted by the acquirer.

Furthermore, the failure to properly retain crucial evidence ¨C such as due diligence records and email correspondence ¨C frequently leaves them unable to prove they exercised reasonable due care. Consequently, financial investors are often placed on the defensive due to this informational asymmetry and inadequate evidence preservation.

Adjudicative logics

In judicial practice, the adjudicative logic typically rests on the following three points:

1. 1. Participation in the fraudulent act, i.e. whether the financial investor directly participated in the fabrication or provided false material, thus constituting joint fraud;
   2. Knowledge of the fraudulent act, i.e. whether the financial investor is presumed to have had a duty of care based on their status as a shareholder, the appointment of a director, historical due diligence records, and other factors; and
   3. Effect of representations and warranties, i.e. whether broadly worded guarantees may be interpreted as providing a comprehensive warranty for the entire transaction documents, thereby negating defences based on independence.

Preventive measures

Isolating risks prior to the transaction. First, financial investors should commission their own due diligence, independently appointing auditors and legal counsel to conduct a penetrating review of the target¡¯s core financial data ¨C such as revenue recognition and related-party transactions ¨C rather than relying on information supplied by the controlling shareholder.

Also, the scope of any representations in the transaction documents should be precisely defined, for example, by limiting them to being based on ¡°material provided by the seller¡± or ¡°information known to the investor¡±, thereby avoiding open-ended guarantees. Furthermore, the inclusion of a clause stating that ¡°each seller acts independently and does not represent the actions of other parties¡± can help sever the chain of liability.

Designing transaction documents. Financial investors can incorporate specific risk-isolation clauses, stating that they are ¡°not responsible for the representations and warranties made by other sellers¡±, and clearly allocating the burden of proof regarding fraudulent acts. The documents should also include a detailed disclosure schedule, requiring sellers to itemise the sources of financial data and any audit adjustments, thus avoiding vague descriptions.

Furthermore, exit mechanisms can be structured with earn-out provisions, linking portions of the payment to performance milestones or compliance rectifications, thereby mitigating the risks associated with a single lump-sum payment.

Devising evidentiary strategies in dispute resolution. Financial investors can present evidence such as records of transaction negotiations and email correspondence to demonstrate their non-involvement in financial fabrication or fraud. Submitting due diligence reports, written inquiries and rectification demands can also illustrate their prudent examination of financial data, serving to prove the fulfilment of their reasonable duty of care.

If the acquirer failed to question anomalous financial indicators, the investor may argue that the acquirer itself neglected its own duty of prudent review, thereby challenging the claim that the investor ¡°should have known¡±.

Addressing criminal risks. Should the controlling shareholder be suspected of contract fraud, the financial investor should promptly submit transaction documents and due diligence records to the judicial authorities to demonstrate an absence of intent to conspire. The investor must also scrutinise the fund flows, conducting compliance reviews of the payment path for the transaction consideration to prevent the misappropriation of funds or money laundering.

Takeaways

In M&A, financial investors must discard the misconception that a passive stake equates to immunity from liability, and instead uphold the duty of care expected of a ¡°prudent businessperson¡±. Only by embedding legal risk management throughout the entire commercial decision-making process can they safeguard their position in complex transactions.

Liang Qiang is a director and chief partner at Zhong Ce Law Firm. He can be contacted by phone at +86 135 0106 8519 and by email at liangqiang@zhongcelaw.com

Li Fangzhe is a partner at Zhong Ce Law Firm. He can be contacted by phone at +86 188 1084 0322 and by email at lifangzhe@zhongcelaw.com