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Mergers and share swaps are common strategies for corporate alliances and rapid value enhancement. When successfully executed, they can yield exponential value and profits. However, if one party commits a significant breach of contract, can arbitration fully compensate the non-breaching party¡¯s losses? This article analyses such issues based on the author¡¯s experience in domestic and international merger and share swap arbitration cases.

Case study

The arbitration claimant, company A, is the transferor in a merger and share swap agreement, with its subsidiary, company B, a well-known domestic brand in real economical industry, as the target company. The original transferee was a consortium of multiple cross-border funds. The transaction involved the original transferee first acquiring all shares of company B, followed by a share swap and merger with company C, selected by the original transferee. This resulted in the original transferee holding partial equity in company C, while company C wholly owned company B.

After completing the above-mentioned share swap transaction, the original transferee, based on the equity transfer contract, channelled funds through company C to indirectly inject capital into company B. This action not only enhanced company B¡¯s valuation but also aimed to use the capital injection primarily to repay company B¡¯s existing major bank loans.

However, due to the misappropriation of the capital injection by company C¡¯s actual controller, company B failed to receive the funds in time to settle its bank debts. This led to litigation disputes between debtor company B, guarantor company A, and banks. Consequently, company A had to initiate arbitration with a domestic arbitration institution in China, as stipulated in the merger and share swap agreement.

Key challenges in arbitration

Objectively, resolution through mediation or self-settlement is often unachievable. In most commercial arbitration disputes, parties retain the option to settle or mediate under the arbitration commission¡¯s guidance before the final award is issued. Article 47, Combination of Arbitration and Mediation, of the China International Economic and Trade Arbitration Commission Arbitration Rules (2024 Edition) and Chapter 6, Combination of Arbitration and Mediation, of the Shanghai International Economic and Trade Arbitration Commission Arbitration Rules (2024 Edition) both provide specific provisions for parties to mediate or settle, encouraging dispute resolution through these means.

However, in cross-border mergers and acquisitions involving fund entities, even though theoretically, fund entities can make decisions through partner or shareholder meetings, practical difficulties arise. Limited partners often cannot reach a consensus, and the executive partner lacks the authority to directly decide on accepting a settlement or the specific terms of the settlement. Consequently, most fund entities, when acting as respondents in arbitration, prefer to await the final arbitration award rather than proactively propose or accept mediation or settlement with the claimant.

Property preservation measures in arbitration. According to article 28 (2) of Arbitration Law of the People¡¯s Republic of China, for a people¡¯s court to take preservation measures on the overseas assets of a foreign respondent, a bilateral or multilateral agreement is required. Additionally, it is challenging to identify and verify the assets and clues of the foreign respondent, creating objective obstacles to preserving overseas assets.

If the final award requires multiple respondents to bear responsibility separately rather than jointly, it will significantly impact the success rate of enforcing the award against the foreign respondent¡¯s assets.

Direct and indirect impacts on the target company. As the target company is established under Chinese law, its preservation measures, such as equity pledge, adopted during the litigation and effective litigation judgments can be accessed through public channels. Additionally, most international arbitration rules allow the arbitration commission¡¯s president or secretary-general to extend the deadline for issuing an award, either once or multiple times, on the tribunal¡¯s request. This results in a longer overall process for foreign-related commercial arbitration compared to domestic litigation. Even if the claimant ultimately wins the arbitration, they often cannot endure until the award is issued. Furthermore, the presence of substantial negative public information about the target company can generate significant negative publicity for its brand and products. Even if a share retransfer/repurchase is stipulated in the merger and share swap agreement, the value of the target company after the share retransfer is often less than its value before the original transfer.

Recommendations

Although the New York Convention makes arbitration awards more enforceable in cross-border scenarios than litigation judgments from the claimant¡¯s home country, the challenges of cross-border arbitration often lie in the enforceability and timeliness of remedies. Additionally, in merger and share swap transactions, it is often difficult to directly assess the final transferee¡¯s performance capability and co-operation intent. Therefore, the following recommendations are made:

• If the counterparty is a foreign entity, request them to provide a guarantee from a domestic affiliate or an on-demand performance bond from a domestic bank.
• In merger and share swap transactions, require the original transferee to guarantee or assume joint liability for the final transferee¡¯s breach of contract.
• Conduct a risk assessment of potential third-party cross-default liabilities due to breaches in merger and share swap transactions, and communicate with third-party creditors in advance to clarify the path for guarantee replacement and evaluate its feasibility.

Zhang Ling (Vicky) is a senior partner at Dacheng Law Offices. She can be contacted by phone at +021 5878 5888 and by email at zhang.ling@dentons.cn
Leung Tszking (Missan) is an associate at Dacheng Law Offices. He can be contacted by phone at +021 5878 5888 and by email at zijin.liang@dentons.cn