The COVID-19 pandemic has greatly disrupted the global economy and supply chain. Vietnam, while being successful in controlling the pandemic, is no exception. Economic growth in Vietnam has drastically slowed compared to last year. Prior to the second wave of Covid-19, GDP was expected to grow approximately between 2.2% and 3.8% in 2020 as reported by the Vietnam Institute for Economic and Policy Research on 21 July 2020. However, Vietnam may end 2020 with a negative growth as a result of the second wave.
The stagnating economy has forced some businesses into financial distress or worse, insolvency, but has opened the door for potential buyers to consider strategic acquisitions that would be unlikely in normal circumstances.
Legal risks and opportunities accompany the acquisition of a distressed or insolvent business. With the aid of experienced advisors, the legal risks can be minimised. This article will discuss the potential pitfalls that buyers should address in a distressed M&A deal in Vietnam.
In any M&A deal, both parties certainly want to minimise their risk exposure, especially if the target is financially distressed. Buyers prefer to acquire the target’s assets and sellers prefer to sell the target’s shares. Finding a compromise might prove difficult. Under normal circumstances in Vietnam, a share sale is the more popular option.
1.1. Asset sale
The main upside of an asset sale is that the liabilities of the target company normally will not transfer to the buyer, which greatly reduces the risk on the buyer during the target company’s financial distress. However, Vietnam’s laws, including tax laws, do not have specific protection for the buyer against claims for outstanding taxes and other liabilities of the target company. As such, in the worst case scenario, tax and other authorities may invoke the substance-over-form rule and assert that the buyer is the new owner of the company, thereby making a claim against the buyer for past tax and other liabilities of the target company. To mitigate this risk, the buyer should negotiate to have warranties and indemnities from the seller regarding past taxes and other liabilities.
Foreign buyers need to set up an entity in Vietnam to hold and use the asset. If a foreign buyer already has an entity in Vietnam, the scope of business of such entity may need to be expanded to facilitate the use of the asset following the purchase.
Depending on the type of asset, both the buyer and the seller may incur tax and other financial obligations. For the buyer, it is value added tax of up to 10% of sale price and the registration fee to change ownership records if required. The seller has to pay income tax on the sale price. As for tax incentives relating to the asset, they will generally not be transferred to the buyer. So, in terms of tax, an asset sale tends to be more costly for the parties. On the plus side, if the target asset meets the definition of a fixed asset under the law, the purchase price can be depreciated for tax purposes of the buyer.
The buyer will also need to pay attention to the third-party approvals needed for the asset sale. These approvals generally include:
- Mortgagee/Pledgee’s approval: If the target asset is mortgaged or pledged to another party to secure an obligation, the sale of such encumbered asset requires approval from the pledgee or mortgagee.
- Consent for change of control: Required if the target asset is subject to a change of control clause in a third-party contract.
- Authority approvals: If the asset sale meets the threshold for economic concentration filing under competition law, the parties must notify and obtain clearance from competition authority before the sale. Authority pre-approval is also required for certain type of assets, for example, a real estate project.
- Contract assignment: Unless agreed otherwise, the assignment of rights and obligations in a contract require the counterparty’s approval.
- Joint owner approval: Required if the target asset is jointly owned with a third party.
- Employee approval: If the buyer wishes to acquire staff from the target company as part of the deal, the buyer will have to negotiate and secure the target employee’s agreement to work for the buyer.
Other than the above, there may be other approvals required specific to the industry and business of the target company and advice on a case-by-case basis is required.
1.2. Share Sale
The main risk associated with share acquisition is that the buyer will acquire interest in the target company together with its liabilities. As such, the buyer should carry out tax and financial due diligence to uncover the target’s liabilities and request relevant warranties or indemnities from the seller. Share acquisition is in most cases faster and simpler than asset acquisition, more so if the transaction is structured offshore.
In share sales, only the seller incurs tax, i.e. the income tax applicable to the seller. However, if the company issues new shares for the buyer, neither parties incur any tax. Depending on the corporate form of the target company, whether the seller is a company or individual and the tax residency status of the seller, the tax rate will differ. It should be noted that Vietnamese tax authorities may make aggressive efforts to tax offshore transactions, despite Vietnamese tax law not being clear on taxing offshore transactions.
For share acquisition, the buyer and/or the seller will generally have to obtain the following third-party approvals:
- Mortgagee/Pledgee’s approval: If the target shares are mortgaged or pledged to another party to secure an obligation, the sale of such encumbered shares requires approval from the pledgee or mortgagee;
- M&A approval for foreign buyers issued by the Vietnamese authority : Under the 2020 Law on Investment effective on 1 January 2021, approval will be required for onshore transactions whereby foreign ownership will be reach 50% (currently 51% under the 2014 Law on Investment, effective until 31 December 2020) or more of the target company’s shares after the transaction, or any percentage if the target company engages in businesses conditional to foreign investors. The M&A approval will also be required in case where the target company possesses a certificate on use right over a land in a frontier or coastal island, town, ward or other areas which have an effect on national defence and/or security. Some businesses put a cap on foreign ownership;
- Competition approval: if the share sale meets the threshold for economic concentration filing under competition law, the parties must notify and obtain clearance from competition authority before the sale;
- Consent for change of control: consent required if the target company is subject to a change of control clause in a third-party contract. This is prevalent in credit agreements. Some creditors may draft the clause to regulate offshore transactions as well;
- Consent of other members/shareholders: consent may be required, and is subject to the target company’s corporate form, constitutional documents and other shareholder arrangements, if not all members/shareholders of the target company sell equity interest to the buyer; and
- Joint owner approval: the buyer should make sure that the sale shares is privately owned by the seller and not jointly owned with any other party such as the seller’s spouse (if the seller is a married individual), or obtain the consent of the relevant party regarding the share sale.
Other than the before-mentioned approvals, there may be other approvals required which are specific to the industry and business of the target company and need to be advised on a case-by-case basis.
1.3. Debt to Equity Swap
The main reason for a distressed sale is the target’s disrupted cash flow, leading to an inability or decreased ability to service debt. As a debt restructuring tool, a debt to equity swap can provide a borrower with the ability to continue to operate without the burden of debt or at least reduce the burden. A debt to equity swap can be deemed as an alternative acquisition structure and, therefore, subject to certain requirements and consents as required under the applicable laws.
If the buyer is not an existing creditor of the target, besides the option of providing the target company a new loan, the buyer can acquire a debt from an existing creditor of the target business, thereby becoming a creditor of the target company. That said, it should be considered whether the acquisition of the debt could be deemed as debt-trade business which requires both the buyer and the seller to satisfy certain requirements before completing the transaction.
In the event the debt is unsecured, the buyer can agree with the target to convert the debt into debt secured by the company’s shares. However, this conversion cannot be done after the company enters bankruptcy proceedings. If the debt is secured by an asset other than shares, the buyer can agree with the company to change the security asset into the company’s shares. How the buyer structures the debt to equity swap is mostly a commercial decision and should be considered on a case-by-case basis.
To best utilise the pros and minimise the cons of the acquisition options mentioned in Section 1, the parties may consider a hybrid restructure, whereby the seller transfers assets into a new company within the seller’s group and the new company is then sold to the buyer. While this may take time, often a seller is better placed to transfer assets and contracts as many agreements permit the transfer or assignment of assets to affiliates. For a seller, the orderly restructuring of the business and sale of a clean new company is likely to maximise the value of the transaction. Change of control or other transfer/assignment consents can then be dealt with subsequently within the context of a clean new company and a known buyer. For a buyer, completing due diligence on a clean entity (including the situation where selected assets have been transferred to it) is preferable to a complex due diligence required when dealing with a distressed target company with liabilities the buyer does not want to take on or only discovers after completion. The key to any restructuring is to ensure that the transfers are completed in a way that protects the buyer and seller from any issues arising under any subsequent insolvency of the seller or the seller’s group.
Due diligence, whilst important in any M&A transaction, becomes particularly important when acquiring a distressed target. In addition to audit activities of loans and other extensions of credit, key contracts and other commitments will also need to be reviewed to ensure that the target has not breached their terms or conditions, and to ascertain the extent of default and liability of the target. A distressed sale usually means that indemnities and warranties are limited, so a buyer will need to be fully aware of all the assets and liabilities of the target prior to the acquisition.
In an asset sale, the focus of the buyer’s due diligence will be on the assets to be acquired. Consequently, the due diligence process can, in many cases, be streamlined. In a share sale of a distressed target, the focus will be the full business of the target company. As such, unless the buyer is willing to accept the risk (which may be the case if the buyer already knows the business of the target), the due diligence will need to be detailed and look at all aspects of the target and its operations.
Nevertheless, the cost of an asset acquisition and the restructuring that may be required can in some cases outweigh the benefits. The decision to proceed with an asset or a share acquisition should be made only after a thorough cost benefit versus risk analysis.
Under Vietnamese law, a company is deemed insolvent when it fails to meet any of its payment obligations within three months from the due date. Once a company falls insolvent, a bankruptcy request can be submitted to a Court by (i) unsecured or partly secured creditors, (ii) employees or trade unions, or (iii) the insolvent company or its qualified shareholders, although there is no specific timeline for this submission. The Court upon receipt of the request may issue a decision to commence bankruptcy procedures, putting the company into bankruptcy proceedings.
If the target company has already become insolvent but no decision to commence bankruptcy procedures has been issued, the buyer should work with the seller to help the target company exit insolvency before bankruptcy proceedings commence at the Court, either by negotiating with creditors or financing the target company to pay its other debts. This is because M&A deals in respect of an insolvent company after bankruptcy proceedings have been commenced are generally very complex, time-consuming and should only be considered by investors if they are very confident that their business purpose can be achieved by acquiring the insolvent target. Further, the purchase price may not be as low as the buyer wishes, due to Vietnamese bankruptcy law preventing undervalued transaction.
After the relevant Court has decided to commence bankruptcy procedures, the presiding judge will appoint an administrator (i.e. licensed individual or company) to manage the company’s assets and business activities.
Activities in connection with borrowing or a pledge, mortgage, guarantee, purchase, sale, assignment, leasing out of the assets, sale or conversion of the shares, or transfer of the ownership rights in any asset of the insolvent company must obtain the administrator’s approval before conducting.
Without the administrator’s approval, the sale of an asset or share of the insolvent target business will be invalidated.
Once the administrator has finished the inventory of the insolvent company’s assets, a conference of the company’s creditors may be convened. At the conference, the creditors can choose to pass a resolution on the recovery of the company’s business that may propose a sale of shares or assets of the company. If such resolution of the creditors is then approved by the presiding Court, the transaction specified in the resolution can then be conducted. Therefore, the buyer being a creditor of the target company may be advantageous, since the buyer can attend and voice its thoughts at the creditors conference. If the buyer is an unsecured or partly secured creditor, it has even more control on the issuance of the resolution, as fully secured creditors cannot vote on the issuance of the resolution of creditors.
A transaction of an insolvent business which was conducted within 6 months (or 18 months if the counterparty is a related party) prior to the date when the Court issued a decision to commence the bankruptcy procedure shall be deemed invalid if it falls into one of the following cases:
- An asset assignment transaction which is not at market price, i.e. undervalue transactions;
- Conversion of an unsecured debt into a debt secured or partly secured by the assets of the insolvent business;
- Payment or setoff which benefits a creditor in respect of a debt that has not yet become due or with a sum that is larger than a debt which has become due;
- Donation/gifting of assets;
- The transaction is outside the purpose of the business operations of the insolvent business; or
- Other transactions for the purpose of disposing of the assets of the business.
If the administrator sees any transaction that falls under any of the above, they shall request the Court to invalidate such transaction. Therefore, for a pre-insolvency transaction, the buyer should carefully assess the likelihood of the distressed target company becoming insolvent within the next 6 months following transaction completion. To mitigate the risk of undervalue transaction, the parties can obtain valuation reports by licensed professionals to prove that the transaction is at arm’s length. The buyer should also ascertain that the purchase price is sufficient for the target to pay its debts or negotiate with the target’s creditors to extend due dates of their loans prior to the transaction to minimize the chance of the target becoming insolvent within the next 6 months from deal completion.
For a seller of a distressed target, one of the most important factors is deal certainty. Where there are multiple potential buyers, aside from the price, deal certainty may be the determining factor for the seller. This means that the seller will tend to resist termination rights that may be typical on non-distressed sales where there is a split signing and completion, including rejecting the right of the buyer to terminate on a material adverse change or breaches of pre-completion covenants, and requiring that consents from the buyer’s side for completing the transaction shall be obtained regardless of any conditions imposed. For the buyer this means that risk will actually transfer on signing, not on completion, though a split signing and completion does exist.
A buyer of a distressed asset is likely to seek assurances that certain events will not happen between signing and completion (for example, the target company will not enter bankruptcy proceedings) and will typically seek a right to terminate the agreement (or walk away) on the occurrence of those events. Triggers for these termination rights often include any steps taken towards insolvency, a loss of any key licenses, customers or contracts or a default under any borrowings. Whether the buyer will succeed in negotiating these termination rights will depend on the relative bargaining power of the parties. For sellers of distressed assets, walk-away rights may be deal breakers, and sellers may demand some sort of security put in place to ensure that the buyer does not terminate the agreement.
In general, due to the adverse effect of COVID-19, distressed companies are starting to consider M&A as a means of recovering business operations. It is crucial for buyers to structure the deal wisely and address the potential pitfalls to maximise the benefits and minimise the risks of acquiring a distressed target.
Huyen Pham / Senior Associate
Duc Tran / Associate
This legal update is not an advice and should not be treated as such.
Open in pdf: Distressed M&A in Vietnam: Issues to take note of
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