Managing Contingent Liabilities in M&A Transactions

In the course of executing a merger and acquisition (M&A) transaction, the buyer must not only assess the current value and growth potential of the target enterprise but also identify and mitigate legal risks that could impact the post-acquisition outcome. One significant risk is that of contingent liabilities – financial obligations that may arise but are not yet recorded in the financial statements or are insufficiently disclosed in the legal documentation. This article examines the legal nature and risk control mechanisms related to contingent liabilities in M&A transactions to safeguard the buyer’s legitimate interests.

1.Concept and Legal Characteristics of Contingent Liabilities

Contingent liabilities are defined as financial obligations that may arise in the future, depending on the occurrence or non-occurrence of uncertain events. Under Vietnamese Accounting Standards (VAS 18) and International Accounting Standards (IAS 37), such liabilities are not recognized in the financial statements but must be disclosed if they are likely to have a material impact on the financial position of the enterprise.

2.Common Sources of Contingent Liabilities

Contingent liabilities are often not fully reflected in financial statements, especially where the target company lacks a robust internal control system or fails to comply with accounting standards. Common sources include:

• Contractual Disputes

The target company may be involved as a litigant in ongoing civil, commercial, or labor disputes currently under review and resolution by competent authorities. These proceedings may give rise to liability for damages in the event of an unfavorable judgment, arbitral award, or decision against the company.

• Financial Guarantee Commitments

The company may have issued letters of guarantee or financial undertakings for third parties (e.g., subsidiaries, joint venture partners) which have not yet been settled. These guarantees may give rise to legal liability if the guaranteed party fails to meet its obligations.

• Unrecorded Financial Obligations

Certain obligations such as debts, maintenance costs, warranty liabilities, or contractual indemnities may not be recorded but could materially impact post-acquisition finances.

• Deferred Prepaid or Unallocated Expenses

Unallocated deferred expenses are costs that have already been incurred but have not yet been recognized as expenses in the current accounting period. Instead, they are “deferred” – that is, temporarily recorded on the balance sheet, typically under prepaid expenses or deferred charges – to be gradually allocated across subsequent accounting periods. Examples include legal consulting fees, advertising costs, and research and development expenses. Failure to disclose these deferred expenses clearly may distort the company’s actual profit or loss.

3.Risk Control Mechanisms in Pre-Transaction Phase

• Legal Due Diligence

A comprehensive legal due diligence is essential to assess the target’s legal standing, particularly its liabilities. Key documents for review include:

• Financial guarantees, letters of undertaking, and intra-group financial obligations;
• Ongoing litigation and dispute files;
• Inspection and audit reports issued by regulatory authorities, especially tax and financial inspectors;
• Contracts containing indemnity clauses or penalty provisions.
• Financial and Accounting Due Diligence

Lawyers should coordinate with auditors and financial experts to analyze deferred expenses, post-reporting period obligations, off-balance-sheet liabilities, and undisclosed internal borrowings.

4.Contractual Mechanisms for Risk Allocation and Control

• Representations and Warranties (R&W)

The buyer should require the seller to make specific contractual representations, including:

• No financial obligations or contingent liabilities exist beyond those disclosed;
• No ongoing disputes that could materially impact financial obligations;
• The company is not guaranteeing any third-party loans, joint obligations, or financial commitments that are not formally recorded.
• Indemnity Clauses

The buyer should include a provision whereby the seller shall indemnify the buyer for any undisclosed financial obligations arising post-closing. The clause should specify:

• Scope of indemnity;
• Limitation period for claims;
• Conditions and procedures for damage verification.
• Holdback or Escrow Arrangements

The parties may agree that a portion of the purchase price will be retained or placed in escrow to address any subsequent financial obligations. This may be administered by a reputable bank or third-party intermediary under a clear release mechanism.

Contingent liabilities represent a serious hidden risk in M&A transactions and can significantly disrupt post-deal financial planning and strategic execution. Addressing such risks cannot rely solely on goodwill; rather, they require robust contractual safeguards, thorough due diligence, and close coordination between legal and financial professionals. Only under such conditions can an M&A deal serve as a true catalyst for growth rather than a latent liability for the buyer.

This article is part of TNTP’s series on “Disputes in M&A Transactions” and focuses on managing contingent liabilities in the context of M&A. Should you have any questions regarding this topic, please feel free to contact TNTP for further assistance.

Sincerely,