How to Consider Employee Settlement Issues in the Early Stage of Merger & Acquisition Deals?
By David Wang Jingan Yang
In the current Chinese legal practice, merger and acquisition (“M&A”) lawyers will be engaged in the large-scale M&A deals at the outset, i.e. when the M&A agreement is negotiated and drafted. However, employment lawyers will normally only participate substantially in the deal after the execution of the M&A agreement in order to implement the employee settlement work. This may result in a problem which is normally ignored by companies, i.e. the design of the structure of the merger and acquisition deals and the content and negotiation process of the M&A agreement may have a significant influence on the follow-up employee settlement work. If M&A lawyers can consider these issues at an early stage, the subsequent employee settlement project will be implemented more smoothly and it will save much transaction cost for companies. The case below illustrates this point.
Summary of the Case (Please note some detailed information below is fictional for confidentiality purpose.)
The acquirer (“Acquirer”) is a well-known state-owned enterprise engaged in tertiary industry who intended to acquire a Sino-foreign joint venture company engaged in manufacturing industry (“Company”). Majority of the Company’s equity was held by a foreign shareholder and the minority shareholder is a state-owned PRC enterprise.
Out of various transaction considerations, the equity transfer was structured into three phases:
transfer of more than 50% shares held by the foreign shareholder to the Acquirer, so that the Acquirer became the controlling shareholder; since the Acquirer was inexperienced in managing manufacturing enterprises, the foreign shareholder kept holding a minimum portion of shares and continuing to manage the Company on a daily basis in the transaction period before the entire 100% shares of the Company was transferred to the Acquirer;
transfer of all shares held by the Chinese shareholder to the Acquirer through bidding and auction, after which the Chinese shareholder would completely quit from the Company (however, this step cannot be guaranteed because a third party other than the Acquirer might win the bidding in the auction by offering a price higher than that of the Acquirer);
Since the Company would be changed from a manufacturing enterprise into an enterprise engaged in the tertiary industry, the Acquirer required the Company to terminate labor contracts with all of its employees. The employee settlement work would be handled by the foreign shareholder after the completion of the Chinese shareholder’s equity transfer. After termination of all employees’ labor relationships or achieving any other settlement results acceptable to the Acquirer, the foreign shareholder could transfer the remaining shares to the Acquirer and the Acquirer would become the sole shareholder of the Company.
The deal was complicated and prolonged because it involves three parties, two of which were state-owned enterprises in China and another was an oversea listed company. When deciding which party shall transfer first, when and how many shares should be transferred each time, the parties have considered many factors, such as the special regulations on the disposal of state-owned assets under PRC law, each party’s judgment on potential business risks of the deal and sharing of such risks among the parties, the need to announce annual financial statements by listed companies in the year end, as well as compliance with practical requirements of PRC foreign exchange control and tax payment. The final arrangement is the result of compromises among three parties.
In the implementation stage of this deal, the employee settlement work became the most difficult and stalled step. Employees requested an extremely high compensation which far exceeded the compulsory compensation amount for termination of labor contract under PRC law. Many factors caused this situation, especially the large number of employees involved, long service years of employees and other employee characteristics. However, the acquisition deal itself had a major impact on employees’ expectation because the information known by the employees during the transaction increased their aspiration on the possible amount of severance fee.
Public Bidding of Share Transfer Price
First of all, since the Chinese shareholder was a stated-owned enterprise, its equity transfer price shall be put up forbidding in order to prevent the loss of stated-owned asset. In this case, the bidding process was conducted online according to the requirement of the local Assets and Equity Exchange and thus the public could observe the whole process online. This online bidding occurred at the moment when the previous controlling shareholder had already transferred the majority of its shares and now the minority shareholder decided to sell all shares held by it as well. So which company will obtain these target shares became the top concern of the employees. When the result of the bidding would decide the fate of the Company, it was predictable that many employees of the Company watched this online bidding process.
Several companies, including the Acquirer, participated in the online bidding process. The transfer price jumped by RMB several ten millions within several hours. After having witnessed the skyrocket of such price, even the most objective and rational employee couldn’t help wishing to share a piece of cake in the transfer price, or at least in the bidding premium. Some employees even held that the amount of severance fee should be 1 million per person.
Although from the legal perspective, most spectators can logically conclude that the share transfer price has nothing to do with the amount of severance fee, it was very hard for the employees, who had made long-term contributions to the Company and faced with the upcoming unemployment crisis, to behave and respond in such an objective and calm way. From their perspective, they felt they were fully entitled to share the profit gained by the shareholders through the share transfer because such profit was gained at the cost of their jobs.
The Shareholders’ Budget for Employee Settlement Work Contained in the M&A Agreement
When the shareholders of the Company and the Acquirer were negotiating details of the M&A agreement, one major topic was which party should be responsible for the settlement of the employees and how the settlement cost should be incurred. It was fair that the Chinese shareholder and the foreign shareholder should apportion such cost according to their respective shareholding ratios. The difficulty was that the final and actual cost cannot be predicted in advance. So, there should be a method to share the potential risks. After negotiation, it was agreed that: (1) the foreign shareholder shall be solely responsible for handling the employment settlement work and bear all costs and risks arising therefrom, including communication with government, maintaining the security of the factory, negotiating with the employees and signing contracts with them, paying severance fee to employees, bearing costs to hire any third party professionals and coping with any potential legal disputes; and (2) as a consideration to exit from the employee settlement work and bearing no risk at all, the Chinese shareholder was willing to calculate its proportional cost based on a very high amount of total severance fee (much higher than reasonable expectation, hereinafter, the “Extreme High Amount”). This negotiation result is an allocation of transaction risks between both parties and has its business rationality.
Although the M&A agreement was negotiated by the shareholders and without any company employee’s participation, the total amount of severance fee borne by the Chinese shareholder for the employment settlement work was still leaked to the employees of the Company. Since the cost borne by the Chinese shareholder was calculated based on the Extreme High Amount, the employees took the Extreme High Amount as the shareholders’ budget directly. In the negotiation process, they regarded this Extreme High Amount, instead of the compensation amount as proposed by the Company which was above legal standard, as the negotiation threshold. They even pushed for more because they thought a budget could always be exceeded as long as enough pressure was imposed. Employees did not care about how the so called budget was calculated and whether there was any business consideration behind such budget. In summary, the leakage of the total amount borne by the Chinese shareholder for the employment settlement work placed the Company in a very passive position in the whole negotiation process and made the Company unable to negotiate with the employees in a normal range.
The above case fully illustrates that the negotiation and implementation process of an M&A deal can easily affect the subsequent employee settlement work. Companies and M&A lawyers shall pay special attention to this fact. Based on our team’s rich experience in handling both M&A deals and labor law cases, we hereby provide the following practical suggestions for dealing with M&A deals which involves large-scale employee settlement:
First of all, as to the employee settlement work, it is usually not recommended to agree on a simple and fixed result of the employee settlement work (e.g. how many employees have to be settled before a certain deadline). Because there is substantial difference between the employee settlement work and other steps of a business deal. The essence of a business deal is to pursue interests and benefits and most transactional steps are generally controllable. For example, the date to complete the payment of share transfer price and the punishment for non-compliance can be specified in the agreement as long as there is sufficient fund in the bank account and there is no obstacle under PRC foreign exchange control policies. However, the essence of employee settlement work is about understanding human nature and emotions. The transaction parties shall not expect to fully control the process and its results. Therefore, it is better for transaction parties to agree that they shall try their best to achieve certain target (e.g. propose targets for termination through consultation, early retirement or change of positions) and when part of the target cannot be realized, the parties shall promptly negotiate for an alternative solution. We would like to emphasize that, no matter which party is contractually responsible for employee settlement work, only the pecuniary responsibility can be divided. It is very difficult for any involved party, either the acquirer or the seller, to stay in a safe harbor and be immune from responding to employees’ emotions and requests.
Secondly, in order to avoid disclosure of deal information which may affect employees’ expectation, the parties should strictly limit the number and level of persons who participate in the M&A deal negotiation and, if possible, request the participants to sign a confidentiality agreement ensuring that they will not disclose any commercial information received (e.g., the background of the acquirer’s shareholders, business budget, etc.) during the deal negotiation to any third party.
Thirdly, it is important for parties to reach consensus that it may take a long time to complete the employee settlement work and enough flexibility shall be left when setting closing conditions in the agreement. Especially for the party which is responsible for employment settlement work, if the conditions for receiving part of the equity transfer price include the 100% completion of the employee settlement target, the receipt of such equity transfer price may be delayed.
Lastly, the party which is responsible for employee settlement work shall consider and plan in advance the type and number of employees who shall be retained during the implementation stage of the M&A deal, e.g., employees to handle production wrap-up, financial, HR and customer communication matters. The party should consider how to handle these employees’ labor relationships and how to encourage them to keep working at their original positions after the announcement of the employee settlement plan. These issues can have substantial impact on whether the employee settlement work can be conducted safely and smoothly.
All in all, outstanding M&A lawyers shall fully estimate the risks of subsequent employee settlement work during the deal negotiation process, shall design legitimate, reasonable and fair employee settlement plan acceptable to employees, government departments and companies, and shall incorporate the principles of such employee settlement plan in the provisions of the M&A agreement to ensure that the subsequent employee settlement work can be conducted smoothly. If clients are inexperienced in employment law practice, it is recommended that labor lawyers shall be involved and their opinions shall be listened to before the execution of M&A agreements.