Arrangements for gains and losses during the transition period in mergers and acquisitions, as a part of transaction pricing, should be made by market players freely through consultation. The Revised Compilation of FAQs Concerning Regulatory Laws and Regulations on Listed Companies, promulgated by the China Securities Regulatory Commission (CSRC) in 2015, specifies that, “for the M&A cases in which the assets are evaluated mainly by the present value of earnings method, hypothetical development method, and other methods based on gains forecast, gains on the assets to be acquired during the transition period (from the benchmark day of evaluation to the closing date) should be attributed to the listed company, while the losses should be borne by the counterparty”; in other words the “mandatory arrangement for transition period”.
The FAQs have been operative since then, and the arrangement appears to provide mandatory protection to the interests of listed companies, and is flawed in many aspects. To probe this problem, the author will give a brief introduction of two basic pricing mechanisms common in M&As in developed markets, namely, the locked box mechanism and the completion accounts mechanism.
The locked box mechanism entails that the purchase price is determined by the assessed value of the target company on the benchmark day of pricing. The price will be fixed and not be adjusted regardless of value calculation.
The completion accounts mechanism is relatively complicated and entails assessment of enterprise value of the target company by income approach on the benchmark day of pricing. As the income approach does not reflect the value of cash and cash equivalents (net of reasonable working capital, referred to as cash) of the target company or its financial liabilities, the share value (i.e., transaction price) should be the enterprise value plus cash, minus financial liabilities. At the time of transaction, the parties will first estimate share value based on the cash and financial liabilities on the closing date, and adjust the value according to the actual amounts on the closing date.
From the above-mentioned, the author has the following points for discussion regarding the mandatory arrangement for the transition period.
(1) It may be detrimental to the marketization of transactions. The locked box and completion accounts mechanisms are essentially different in attribution of gains or losses during the transition period. In the locked box mechanism, the gains or losses during the transition period should be attributable to the buyer, and the risks of the target assets should be transferred to the buyer on the benchmark day of pricing.
The completion accounts mechanism is to the contrary. Neither one is counted superior or inferior to the other in protecting any party to the transaction. The parties may negotiate adoption of the pricing mechanism when considering which party plays the dominant role in the operation arrangement during the transition period. The mandatory arrangement for the transition period deprives the parties of the space for negotiation over this issue, and apparently leaves the arrangement to the listed company, which is the more powerful market player.
(2) It is suspected of distorting an income approach. The mandatory arrangement for transition period is aimed at the gains or losses of the target company, which generally are construed to be its net profit during the transition period. One of the application scenarios of the income approach is for an unprofitable start-up in the near term, but of high earnings expectations in the long run. Even for a mature enterprise with stable profit, that profit curve may fluctuate seasonally.
Both enterprises may have losses during the transition period. The author believes that it is a distortion of the income approach to request the target company to immediately make up for such loss. Application of the income approach does not mean that the target company promises gains, and no losses, from then on in every examination period, whatever its length, and even just for the transition period.
(3) It implies distrust of the income approach. The completion accounts mechanism is aimed at the relative values of cash and financial liabilities of the target company during the transition period. It is essentially different from the mandatory arrangement for the transition period, which targets net profit. The completion accounts mechanism does not change the enterprise value of the target company. In other words, it does not affect the judgment on future earnings forecasts, and merely excludes business performance from the share value during the transition period.
The asymmetric design of the mandatory arrangement for the transition period does not merely “exclude business performance from share value”, but adds a short-term profit test to the target company. This is an unnecessary move since the parties have confidence in the profit forecast in the following years (in practice, a strict profit compensation scheme would be in place).
As early as 2010, the CSRC promulgated the Focuses of Audit Opinions on Issues Common in M&A and Restructuring, and did not impose mandatory requirements on attribution of gains or losses during the transition period in income-approach M&A cases.
Instead, it points out that, “if the gains during the transition period are not attributed to the listed company as agreed, focus should be on whether reasonability of the evaluation of target assets will be affected, and whether the parties to the transaction have made other equivalent arrangements”.
It can be inferred that the focus is laid on equivalence of the transaction arrangement. The CSRC issued the revised focuses in May 2015, yet the FAQs were issued only four months later, which clearly was in response to the superheated M&A market. Today, however, the focuses are outdated by the tide of market-oriented reform represented by the registration system. The author believes that the important capital market of M&A of listed companies may grow mature only when listed companies are given more autonomy in all terms of M&A.
Gong Ruozhou is a salaried partner at Grandway Law Offices.
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