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Generally, there are three preliminary stages in which the majority of acquisition calamities can be avoided from the outset. Those are: 1) the negotiations, 2) the due diligence and 3) the drafting of the contract and other transactional documents. In this paper we will not discuss corporate synergies or developing realistic business plans, which also are essential to long-term success. This paper discusses some of the early failures that can doom the ultimate success of an acquisition long before the ink dries on the contract.
I. Carefully Plan the Negotiations
You’ve made contact with a seller or prospective business partner in Mexico, the business to be acquired or entered into looks attractive, so what is the next step, and what potential pitfalls must you be wary of?
The first step is determining what strategy will be used for negotiations. Frequently it is advisable for the principal (the CEO of the acquiring company, for example) to stay above the rough and tumble negotiations. Often such negotiations can be very agitated, and are almost always emotional. It is usually helpful to have a “bad guy,” such as a lawyer or broker—preferably from outside your company—handle the details of the negotiations under your strict instructions. The CEO or the person in the company with direct decision-making powers over the negotiations should reserve his or her direct intervention only for special instances when he or she can come in as a friendly white knight and cinch some aspect of the deal.
Part of that first step of planning a successful strategy involves determining exactly what you want out of the negotiations, with well-defined fall-back positions. It is always important to decide at what point you would be prepared to walk away from the deal—and then stick to that decision.
In the negotiations stage, there are two potential problems that can spell disaster for the deal even if it goes through. The first is not wanting the deal enough, or having too many doubts about the deal, but stubbornly plodding ahead anyway. If you have significant doubts, then you probably shouldn’t do it.
The second way to ensure disaster is to want a deal too much. It is surprisingly frequent that an acquiring company wants the deal so badly that it will ignore critical facts, many of which are uncovered by the due diligence review discussed in more detail below. The consequences of ignoring those facts can include the complete disintegration of the acquired business.
A Common Blackmail Ploy Used by Sellers
One of the most common ploys pulled by sellers of small to medium-sized privately-held (usually family-owned) Mexican businesses is to wait until the buyer thinks everything is settled—sometimes just hours before the closing—and then say, “We just realized that with all the taxes we’re going to have to pay, we simply can’t afford to sell.” The potential buyer has invested months of time and resources, the due diligence review is done, all the negotiating points supposedly decided, funds have been channeled to a payment account ready to be wire transferred to the seller’s account upon signing of the contract, the acquiring corporation has geared up to begin the operational aspects of taking over management, and then all of a sudden it appears the whole thing will go up in smoke.
“Of course,” the sellers might say, “if you increase the price to cover our taxes, we could go ahead with the deal.” Or maybe they will suggest some off-the-record payments to an offshore account that they will never declare to the tax authorities. Then what would you, as the buyer, do? Do you walk away and give up all the months of investment, or do you give in to what is, essentially, blackmail?
If this happens, it indicates a flaw in the strategy used in the months of negotiations leading up to the closing. It also demonstrates the advisability of using outside counsel for at least a portion of the negotiations. This “bad guy” must make it clear from the outset of the negotiations that the slightest surprise at any stage will make the buyer just walk away. This point must be reinforced frequently during the negotiations, and the specific point of who will be responsible for paying taxes must be raised again and again. If the negotiator is strong, and properly deals with these issues throughout the process, it is highly unlikely the sellers will feel sufficient latitude to pull this card out of their sleeve.
II. The Importance of Performing a Due Diligence Review
A due diligence audit of the target of a merger or acquisition is an essential process in uncovering potential problems or liabilities. Investors sometimes ignore this step, for reasons of expediency or cost savings or because they believe the representations of the seller that there are no problems. Inevitably, this attitude comes back in some form to haunt the purchasers.
Depending on the size of the target company and the nature of its operations, the due diligence audit can be structured to reduce the time and expense required.
Here are some real examples we have seen of possible consequences of failure to conduct a proper due diligence audit:
- Shareholders unknown to the buyers, some with sufficient holdings to entitle them to minority rights, are discovered that were not disclosed by the sellers.
- Stock transfers that were never registered or improperly registered in the corporate books, creating potential corporate liability to shareholders, as well as possible tax liabilities.
- Bylaws that prohibit foreign participation in the company, which was common in Mexico in years past. This must be corrected for any transfer of shareholding to a foreign entity to be valid.
- Failure to properly register any foreign investment with the proper authorities, which can mean fines to the company.
- Contracts with clients or suppliers, especially any providing for exclusive relationships, frequently require notification of any changes in the corporate structure or shareholdings. Some even provide for termination of the contract in the event of any changes in corporate structure or shareholdings. Failure to spot and adequately deal with that type of contractual requirement might result in a costly loss of an exclusive relationship.
- Environmental problems that could imply fines and, under certain circumstances, even closure of the facilities and liability for costly environmental cleanup.
- Certain clauses in real estate leases or contracts, or failure to determine proper title, either of which could result in lawsuits against the company and the loss of the use of the facilities.
- Related party transactions must be scrutinized. It is not uncommon in privately-held Mexican companies that a considerable portion of the company’s business is conducted with entities related to the owners of the company. If this is not caught, a purchaser of the company may just discover to his or her dismay that the majority of the newly-purchased company’s customer base simply disappears overnight, leaving the company in or near bankruptcy.
- Problems of proper documentation and registration of board of director and shareholder meetings and stock and other transactions in the corporate books that should be corrected prior to closing.
- Amazing as it may sound for its blatant illegality, we have seen substantial liabilities in some companies that have withheld taxes and obligatory retirement savings system deductions from workers´ paychecks, but then never paid that money to the government. This situation is not uncommon. Anyone acquiring those companies would acquire those liabilities as well, not to mention having to deal with any criminal fraud consequences.
Some of these potential hazards—and there are many, many more not listed here—may seem trivial or highly unlikely (such as the unknown shareholders in the first example), but these are real problems that occur in Mexico more frequently than you might think.
If the auditing firm botches the due diligence and lets some very serious issued go undetected before the acquisition, it is can be extremely difficult and costly to remedy the situation. It is often the hapless buyer rather than the seller who ends up stuck with the costs to cure the company. Especially in environmental matters, those “cures” can sometimes be very expensive. Fines and other costs for failure to comply with the myriad environmental laws can be substantial. If an environmental cleanup is necessary, depending on the specific circumstances, the costs could be astronomical. Labor fines and back-withholdings and penalties also can be significant. As with any problem, the key is early detection by performing a professional due diligence investigation.
Among some of the specific areas that should be reviewed are the following:
Corporate
Partial list of Documentation to be analyzed[1]: Organizational documents; current bylaws; records of shareholders and board of directors meetings; stockholder registry and changes in ownership; foreign investment registration; powers of attorney; corporate property in other jurisdictions, including offices, storage of inventory, etc.; past dividends payments to shareholders, powers of attorney, stock certificates, etc. should all be carefully analyzed.
Bylaws usually contain items that may be in separate agreements in other countries, such as shareholder agreements or management agreements. Are there any rights of first refusal or other preferences? Are there any requirements for transfer of stock that must be complied with? Are all stock subscriptions fully paid up? Bylaws should contain the manner in which corporate officers are selected, and what limitations may be placed on management. Bylaws may also prohibit foreign participation in the company, which was common in Mexico in years past. This must be corrected for any transfer of shareholding to a foreign entity to be valid. If the company currently has foreign investment, the foreign participation must be registered and up to date with the proper authorities, or fines could be imposed.
Problems of proper documentation and registration of meetings and transactions in the corporate books should be corrected, if possible, prior to closing. Sometimes in privately-held corporations, shares are transferred informally among family and friends without any corporate documentation.
Friendships—even family relationships—in business have a way of turning sour over the years, and a former shareholder or director could turn up and dispute an alleged sale of shares or loss of a director’s position. Shareholders have ownership of stock, so as owners their legal actions are not readily subject to statute of limitations provisions, and they—or even their heirs—could suddenly turn up to demand their portion of the corporation.
In addition, corporations are responsible for ensuring that all applicable taxes are paid on stock transfers, and if the parties did not pay the proper taxes, the corporation may be liable for the tax as well as any fines. The solution to such problems depends on the specific circumstances, but they must be discovered and dealt with before the closing to avoid problems for the new owners.
Powers of attorney are specifically regulated in Mexico under code law, and they are strictly construed by courts. Frequently powers of attorney are poorly drafted, and under the Mexican legal structure, do not legally confer the powers intended. All powers of attorney should be reviewed carefully to be sure who has the legal authority to sign off on any agreement, according to the type of agreement or contract being signed.
Stock certificates must contain specific legal requirements, which must be verified in any due diligence. The physical certificates must be analyzed to determine whether they comply with current law. To give just one example, since December 30, 1982, the law no longer recognizes the validity of bearer shares. As of that change in the law, all bearer shares were required to have been turned in to the corporation and exchanged for nominative shares. If the current shares are still bearer shares, that matter has to be addressed prior to the closing.
Also, the share certificates must be signed by an officer of the corporation in accordance with the legal dispositions governing shares, as well as with the corporate bylaws.
In general, all corporate issues should be reviewed with three things in mind:
1) Are all the corporate documents in order, completely correct and legal to enable the contemplated transaction to proceed?
2) Are there any omissions, defects or problems that must be cured prior to the closing of the transaction?
3) What modifications will the new owners want to make in the corporate structure, powers of attorney, bylaws, etc. to be consistent with the new owners’ specific needs and circumstances that should be changed either prior to or immediately following the closing? What new regulatory requirements will be necessary following the closing (such as new foreign investment registration)?
Environmental
Partial list of Documentation to be analyzed: Environmental impact authorizations; emissions permits; wastewater permits; operations and maintenance logs; wastewater analysis results; hazardous waste generation logs; results of noise analysis from fixed and moveable sources.
In some cases water, soil and air testing should be conducted to be sure the premises do not have more severe pollution problems. Remediation of contaminated soil or water can be very costly. Obviously, the time to find out about such problems is before the acquisition.
Mexico adheres to successor liability principles regarding environmental pollution. Even leased premises can result in liability on the part of the lessee if the premises are contaminated. At the end of the lease, industrial tenants must conduct testing to demonstrate the condition of the soil and subsoil upon leaving the premises. If contamination is found, there is a legal presumption that the tenant who was operating in the facility is the responsible party. That is why some form of environmental due diligence is always recommended even in cases of leased property.
Real Estate
Partial list of Documentation to be analyzed: All required building permits and other licenses, deeds of title, leases, earthquake zone designation. Thorough title searches should be undertaken to determine potential liabilities such as easements and recorded liens.
Title searches in Mexico present special problems. In some jurisdictions even government records are incomplete or inaccurate. Extra efforts must be made to root out any potential problem. Nothing should be taken for granted with Mexican real property.
One example of potential problem areas involves property that was formerly communal ejido land, which is governed by special laws and alienation procedures. Former ejido properties can be large or small, and can involve residential or industrial uses. Current owners-occupiers could end up losing everything if the land was not properly transformed from ejido to private property, carefully following all the tedious procedural requirements.
Whether purchasing a property or simply leasing, you cannot afford to risk your business on a slipshod or incomplete real property investigation. Be sure real estate forms part of the diligence review for any investment in Mexico, and be sure it is conducted professionally and thoroughly.
Related-Party Transactions
Corporate and contract investigations also can reveal related-party transactions. It is not uncommon in privately-held Mexican companies that a considerable portion of the company’s business is conducted with entities related to the owners of the company.
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Typical cases are even more complex, with five to ten related companies doing business with each other. Sufficient investigation of suppliers and customers must be undertaken to ensure that they are not related parties.
Contracts
Partial list of Documentation to be analyzed: Client and supplier contracts; lease agreements; buyback agreements, shareholder agreements and all other potential contractual liabilities.
Supplier (even exclusive distribution agreements) or customer contracts can include language terminating the contract in case of a significant change in company ownership. Many such agreements at least require advance notification of any change in corporate structure, shareholding or management of the company. Failure to spot and comply with that type of contractual requirement might result in a costly loss of an exclusive relationship.
It should be noted that this is only a partial list of important areas and documents that should be reviewed. Any complete due diligence review would also include full analysis of:
- Federal, state and local tax compliance;
- Labor obligations and liabilities;
- Insurance coverage;
- Worker training and accident prevention programs currently in place;
- Employee withholdings;
- Pension plans;
- Claims, litigation or actions, including labor claims, government proceedings, third-party claims, etc.
- Anti-trust issues;
- Technology and intellectual property
Many problems can be uncovered with proper analysis of these and other issues.
III. Pay Attention to the Transaction Documents
No matter whether the deal involves an acquisition, a merger or a joint venture, when most of the final details have been decided, at some point someone will present a contract. It is an idiosyncrasy of Mexican lawyers that contracts frequently are amazingly, even ridiculously short. Once, in a rather complex US$ 10 million purchase of a Mexican company, opposing counsel presented me with a five-page contract—and most of it involved recitals of the corporate authority and powers of attorney enabling the representatives to sign the contract. It virtually had no meat at all, and certainly offered no protection for either party. It is important to pay attention to the transaction documents, because they are what protect you if things go wrong.
All documents related to the transaction itself must be carefully drafted in light of Mexican law. One common example involves non-competition agreements or clauses, which, as such, can be unconstitutional in separation agreements unless properly structured.
Mergers, acquisitions and joint ventures in Mexico can bring enormous rewards, but a methodical, precautionary approach is essential. Your insistence upon absolute precision in language, corporate documents, contracts, due diligence reviews, etc. will prove to be an invaluable safety net for your Mexican business ventures.
[1] Obviously our purpose in this paper is not to list all the documents that should be requested and carefully reviewed. Often just the list of documents in a due diligence can reach 20 or 30 pages. The purpose here is not to provide an extensive list, which really should be determined on a case-by-case basis depending on the specific circumstances, but rather to give an overview of the due diligence process and describe some of the special problems of due diligence investigations in Mexico.
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