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As a core pre-transaction procedure for capital market transactions including mergers and acquisitions, private equity investments, financing and IPOs, legal due diligence essentially relies on systematic legal review and risk identification to furnish reliable legal grounds for clients’ commercial decisions. It also performs substantive risk prevention functions throughout all phases, such as transaction structuring, negotiation of transaction documents and setting of closing conditions. For lawyers, legal due diligence is far more than simple document collection and data entry. It requires comprehensive deployment of legal professional judgment, commercial logic analysis and accumulated transaction experience. Within limited time and information constraints, lawyers shall accurately identify core legal risks that may endanger transaction security, and present such risks clearly and prudently in due diligence reports.

This article focuses on practical key points for lawyers conducting legal due diligence, covering work strategies at the pre-diligence stage, review methodologies for core areas, approaches to identifying and analyzing prevalent legal risks, and professional drafting standards for due diligence reports. It aims to deliver practically instructive references for practitioners.

I. Preparatory Stage for Due Diligence

(I) Alignment with the Client

Sufficient communication between lawyers and clients prior to launching due diligence generally determines the work direction and depth of the entire project. Beyond understanding the client’s basic demands, lawyers at this stage need to thoroughly grasp the client’s transaction logic, risk tolerance boundary and valuation judgment on the target company, so as to prioritize targeted work during due diligence.

The focus of due diligence differs fundamentally under varying transaction purposes and structures. In full equity acquisition transactions, core review targets include historical equity defects of the target company, encumbrances on shareholders’ equity, and completeness of contingent liabilities. For partial equity investment transactions, the compatibility between core clauses of shareholders’ agreements (including liquidation preference, anti-dilution provisions, tag-along rights, etc.) and the existing equity structure of the target company carries greater practical weight. Under asset acquisition scenarios, the clarity of title and transferability of target assets constitute primary considerations. In addition, pre-IPO legal due diligence must be conducted item by item in strict accordance with review standards of the China Securities Regulatory Commission and stock exchanges. Lawyers shall clarify the applicable compliance framework with the client before commencement.

In terms of communication format, it is advisable to confirm the scope of due diligence, key matters, time schedule and mutual information cooperation obligations via formal emails or written memoranda. This avoids extra disputes arising from divergent understandings during project implementation, and also retains clear written records for lawyers to evidence performance of their duty of care.

(II) Dynamic Formulation of Due Diligence Checklists

The due diligence checklist serves as the framework for the entire due diligence exercise and directly affects the completeness of information acquisition and work efficiency. Practically, lawyers should not merely adopt templates mechanically when drafting checklists; instead, they shall build a targeted information requirement system based on in-depth understanding of the specific project.

The structure of the checklist shall align with the table of contents of the final due diligence report. This improves efficiency throughout document collection, file organization and report drafting, and mitigates omission risks caused by disorganized information filing. Meanwhile, the checklist shall distinguish two categories of information: publicly verifiable official information and company-provided materials. For the former (e.g., industrial and commercial registration information, judicial inquiry records, intellectual property database records), corresponding official inquiry channels shall be clearly marked in the checklist. Information supplied by the company cannot substitute official verification. The latter will serve as the basis for lawyers to specify information sources when citing materials in reports.

A due diligence checklist is not a static document finalized once and for all upon project initiation; it shall be iteratively updated as due diligence proceeds. In practice, continuous collection of materials and gradual surfacing of issues often generate numerous unanticipated information demands not covered in the initial checklist. For example, upon discovery that the target company has provided external guarantees, requests for supporting documents including principal guarantee contracts, counter-guarantee arrangements and guarantee registration filings shall be promptly added to the checklist. Where procedural questions emerge regarding historical equity transfers, further requests shall be made for contemporaneous shareholders’ resolutions, notification documents and consideration payment vouchers. Lawyers shall treat such dynamic adjustments as an important embodiment of high-quality due diligence, rather than a burden on process management.

For progress tracking, electronic checklists should adopt four status labels: Fully Received, Partially Received, Not Received and Not Applicable, which shall be updated timely after each follow-up on materials. This enables timely identification of material gaps and forms grounds for issuing supplementary information requests to the target company.

II. Core Review Areas of Legal Due Diligence

(I) Company Establishment and Historical Development

Lawful establishment and valid subsistence of the target company constitute the fundamental prerequisite for all transactions. Nevertheless, review of historical development in practice often uncovers substantial legal risks concealed beneath surface-level information.

In terms of verification approaches, apart from retrieving basic industrial and commercial registration data via the National Enterprise Credit Information Publicity System, applying to the competent market supervision authority for complete industrial and commercial files is an indispensable verification step. This is particularly critical for companies with frequent historical equity transfers, long operating histories or complex early establishment backgrounds. Successive articles of association, shareholders’ resolutions, equity transfer application materials and other original documents preserved in industrial and commercial archives serve as vital evidence to verify the compliance of equity history. Materials unilaterally provided by the company may be selectively submitted or materially inconsistent with officially filed versions.

Lawyers shall focus on identifying the following prevalent risks:First, discrepancies between the version of the articles of association supplied by the target company and the officially filed version. Such differences may touch on core clauses governing shareholder rights, profit distribution and major decision-making procedures. The officially filed version shall prevail, and discrepancies as well as their potential impacts shall be explicitly stated in the report.Second, incomplete supporting procedural documents for successive equity transfers, including corresponding shareholders’ resolutions, original equity transfer agreements and consideration payment vouchers. Such procedural defects are common among technology enterprises that have undergone multiple rounds of historical financing. Lawyers need to assess whether such defects affect the legal validity of the current equity structure based on specific circumstances.Third, cases where the maturity date for subscribed registered capital is approaching while paid-in progress lags significantly. Against the backdrop of the 2024 revision of the Company Law tightening paid-in capital requirements, substantial impacts of shareholders’ capital contribution replenishment obligations on the target company’s cash flow and transaction arrangements require focused evaluation.

(II) Shareholders and Equity Structure

Review of equity structure forms a core chapter of legal due diligence, and also represents the area with the highest risk of information distortion in practice. The underlying reason is that opaque arrangements at the equity level (such as equity nominee holdings, contractual control and implicit valuation adjustment mechanisms) are directly tied to the vital interests of the target company, which lacks inherent motivation to make full and voluntary disclosure.

1. Identification and Analysis of Equity Nominee Holdings

The difficulty in identifying equity nominee holdings lies in the fact that such arrangements are usually not reflected in any industrial and commercial registration information, and the target company rarely volunteers such information during interviews. Lawyers must therefore proactively detect potential nominee holdings through cross-verification. In practice, the following signals merit close attention:

Historical equity transfers effected at consideration markedly below reasonable market levels, without commercially plausible explanations for the relationship between the transferor and transferee;

Evidence showing that capital for shareholder contributions originates from third-party remittances rather than bank accounts registered under the nominal shareholders;

Material inconsistency between actual participants in major corporate decisions (including voting at shareholders’ meetings and board deliberations) and shareholders recorded in industrial and commercial filings;

Ambiguous explanations provided by the target company during interviews regarding the funding background or investment rationale of specific shareholders, or obvious contradictions between statements made by different management personnel.

Once nominee arrangements are identified, lawyers shall not merely record the existence of the nominee relationship but also conduct comprehensive analysis in the report covering:

Core clauses under the nominee agreement (including voting power delegation, ownership of dividend rights, conditions for termination of nominee arrangements, etc.);

Impacts of the reasons for nominee holdings (e.g., circumventing foreign investment access restrictions or disclosure requirements for related-party shareholdings) on the target company’s compliance and transaction feasibility;

Disposal arrangements for nominee relationships post-closing of this transaction and their legal viability;

Specific recommendations for clients to secure coverage via representations and warranties, special indemnity arrangements and other mechanisms in transaction documents if standardized cleanup of nominee holdings cannot be completed prior to closing.

2. Other Prevalent Equity Risks

Where a limited liability company transfers equity, other shareholders enjoy statutory preemptive rights. Failure to issue written notices to all shareholders and complete the waiting period procedure in accordance with law carries legal risks that other shareholders may exercise preemptive rights and impair the validity of the transaction. While verifying compliance of historical equity transfers, clear recommendations shall be put forward for transfer procedures under the current transaction. In respect of equity pledges, all pledge registrations shall be verified via the market supervision authority’s equity pledge registration system. The target company shall be requested to provide corresponding pledge agreements and underlying debt contracts. Emphasis shall be placed on assessing the scale of secured debts, maturity schedules, current performance status, and the likelihood and avenues for the pledgee to enforce security after completion of this transaction.

(III) Major Assets

Major assets of a target company generally include real estate (land use rights and buildings thereon), machinery equipment and fixed assets, intellectual property rights (trademarks, patents, copyrights, software copyrights, etc.), financial assets (bank deposits, accounts receivable, equity investments), and intangible assets such as franchise rights and administrative permits. Asset structures vary drastically across industries. For manufacturing enterprises, core assets usually consist of factory premises, equipment and production land; technology-oriented enterprises rely predominantly on intellectual property and technological accumulation; for service enterprises, key assets may lie in franchise qualifications and core customer contracts. Accordingly, before conducting asset review, lawyers shall first identify which category constitutes the core value of the target company by reference to its industry attributes and business model, and allocate limited investigation resources to such assets.

General review principles are set forth below:First, verification of the authenticity and integrity of title cannot rely on a single source. Asset lists and title certificates provided by the target company must be cross-checked through official channels, including inquiries at real estate registration centers, verification via intellectual property authority databases and industrial and commercial equity pledge registration checks. For all matters verifiable via official channels, company-supplied documents cannot replace official information.

Second, systematic identification of encumbrances is required. Whether major assets are subject to mortgages, pledges, attachments, objection registrations and other real rights encumbrances constitutes a review dimension equally important to title confirmation. Under certain transaction structures, encumbrances attached to assets will not only hinder normal asset usage but may also directly impair the client’s rights and interests post-closing. All such encumbrances must be itemized in the report, with assessments of their impacts on transaction arrangements.

Third, the compliant usage status of assets requires independent evaluation. Clear title to assets does not equate to compliant usage. Consistency between registered land usage and actual utilization, completeness of construction procedures for buildings, and compliance of equipment operation with work safety standards all represent non-negligible compliance dimensions of asset review.

Due diligence for specific asset categories:

1. Real Estate

Real estate review shall comprehensively cover title cleanliness, compliant asset usage status and potential title restrictions. In terms of verification approaches, apart from examining real estate title certificates, inquiries regarding registration of encumbrances (including mortgages, attachments, objection registrations, etc.) shall be conducted at real estate registration centers. Land usage categories and transfer terms shall be verified with natural resources authorities, and filing status of housing lease contracts with housing and urban-rural development commissions.

Lawyers shall pay particular attention to the following real estate risks in practice:

Mismatch between registered land usage and actual utilization (e.g., using industrial land for commercial office activities or purposes other than production operations). Against a tightening regulatory environment, such cases face substantial risks of rectification orders or administrative penalties;

Core factory premises or office premises of the target company without real estate title certificates, representing legacy unlicensed status. Feasibility of obtaining title certificates and material impacts on the enterprise’s continuous operation require assessment;

Imminent expiration of land transfer terms, calling for evaluation of renewal costs and policy uncertainties affecting the target company’s long-term operation;

Housing lease contracts not filed in accordance with law. Under certain judicial practices, this may impair the effectiveness of leases against bona fide third parties and thus undermine the target company’s continued right to use business premises.

2. Intellectual Property Rights

Intellectual property rights differ intrinsically from tangible assets such as real estate and machinery equipment. First, intellectual property rights are intangible; their existence and status depend entirely on administrative registration and legal confirmation and cannot be verified via on-site inspections. Lawyers’ judgment on title can only be based on official database inquiries and title documents supplied by the target company, rendering official verification irreplaceable for intellectual property due diligence. Second, intellectual property rights may serve as capital contribution targets and be injected into the target company’s equity structure via capital contribution in kind. This means title defects or overvaluation of intellectual property will not only affect the assets themselves but may also transmit upward to compliance of the target company’s registered capital, triggering cascading impacts on equity structure stability. These two unique features necessitate a review methodology distinct from tangible asset verification, with heightened attention to the following specific risks:

First, risks where title is not vested in the target company. It is common in practice that core trademarks, patented technologies or software systems deployed by the target company in daily operations are registered under affiliated enterprises controlled by the de facto controller or natural persons. Although licensing agreements may exist to authorize usage, the target company’s utilization of core intellectual property relies on continuous authorization from the licensor. Stability of licensing agreements (including term, revocation conditions, change-of-control clauses, etc.) directly bears on the target company’s ability to operate sustainably post-transaction and constitutes a material latent risk. More severely, relevant core intellectual property may have been preemptively registered by third parties or subject to external title disputes, exposing the target company to litigation risks for infringement. Such matters must be flagged separately as material risks in the report. Verification can be implemented by cross-checking registered owners via official platforms of the National Intellectual Property Administration Trademark Office and patent retrieval systems.

Second, cascading risks arising from intellectual property capital contributions. Where intellectual property rights are contributed in kind to the target company’s registered capital, lawyers shall conduct special review focusing on the following aspects:

Whether the valuation upon capital contribution was supported by a formal appraisal report issued by a qualified appraisal institution with reasonably grounded valuation conclusions;

Whether title transfer procedures for contributed intellectual property have been completed in accordance with law, including registration changes for trademarks and patents. Deficiencies or defects in title transfer procedures cast doubt on the legal validity of the capital contribution and correspondingly trigger legal risks regarding compliance of paid-in registered capital;

Whether the intellectual property subject to contribution remains valid (e.g., whether trademarks have been renewed, whether patents have lapsed due to unpaid annual fees). Extinction of intellectual property rights as contribution targets poses direct legal challenges to compliance of corresponding paid-in capital;

In addition, obvious overvaluation of intellectual property used for capital contributions, especially for large contribution ratios, may constitute substantive false capital contribution and trigger shareholders’ obligations to replenish capital and corresponding legal liabilities.

(IV) Labor and Employment

Labor and employment represents an area with high information distortion rates, frequent post-transaction risk outbreaks yet relatively insufficient pre-transaction attention in M&A due diligence. It often results in unplanned labor costs and dispute risks for clients after transaction closing.

Non-compliance with social insurance and housing fund requirements is highly prevalent among domestic enterprises. Numerous enterprises have long paid social insurance and housing funds based on bases significantly lower than employees’ actual wages, while failing to secure coverage for many employees. During review, lawyers shall require the target company to provide social insurance and housing fund payment records for the latest twelve months, cross-compare such records against payroll records, and quantify historical arrears and potential supplementary payment obligations to enable clients to reasonably quantify such contingent liabilities during pricing negotiations. Social insurance payment records may be assisted via the National Public Service Platform for Social Insurance, and housing fund payment status via official websites of local housing provident fund management centers.

Beyond verifying whether all employees have executed written labor contracts, review of labor contracts shall focus on the following scenarios:

Failure to renew contracts after two consecutive fixed-term labor contracts, which triggers a statutory obligation to enter into open-ended labor contracts; failure to do so exposes the enterprise to risks of double wage compensation claims;

Completeness and enforceability of non-compete and confidentiality agreements for core technical staff and senior management, which are especially critical for technology-intensive enterprises. Lawyers shall verify whether non-compete compensation is agreed and actually paid in accordance with law; otherwise, relevant clauses risk being unenforceable;

Personnel engaged under labor dispatch or flexible employment arrangements yet forming de facto labor relationships. Risks of labor relationship characterization shall be assessed based on actual management conditions.

For enterprises highly dependent on core talents, retention of key employees itself materially affects the operating value of the target company. During interviews, lawyers shall ascertain whether core employees hold options or profit-sharing arrangements, the continuity of such incentive schemes upon change of control, and the target company’s retention capacity. Relevant findings shall be truthfully reflected in the report.

(V) Litigation, Arbitration and Administrative Penalties

This area demands proactive verification efforts by lawyers, because the target company, driven by self-interest, demonstrates an obvious tendency to selectively disclose adverse judicial and administrative records. Systematic proactive verification shall cover the following channels:

China Judgments Online: to retrieve published civil, commercial and administrative judgments;

China Enforcement Information Publicity Network: to verify judgment debtor information and assess debt performance status of the target company, major shareholders and de facto controllers;

List of Dishonest Persons Subject to Enforcement published by the Supreme People’s Court: for checking dishonesty records;

National Enterprise Credit Information Publicity System: for administrative penalty records covering market supervision, taxation, environmental protection, work safety and multiple other regulatory dimensions.

Special attention shall be paid to the absence of a unified national public inquiry channel for arbitral awards. Where the target company states that no arbitral disputes exist, limitations of available inquiry channels shall be clearly specified in the report, and the target company shall be required to issue a corresponding written undertaking.

In report drafting, for concluded litigation cases, basic case information, judgment outcomes and enforcement status shall be listed. For pending cases, the amount of claims and relief sought shall be specified, and risks of adverse judgments plus potential financial impacts evaluated on a case-by-case basis. For historical administrative penalties, lawyers shall analyze whether the underlying causes systematically reflect deficiencies in the target company’s compliance management, rather than isolated incidental incidents.

(VI) Related Transactions and De Facto Controllers

Related transactions constitute one of the core matters subject to intense scrutiny by regulators during IPO reviews. Identification of related parties shall not be confined to equity connections reflected in industrial and commercial registration data. Through interviews, lawyers shall thoroughly identify all entities controlled by the de facto controller, enterprises held or controlled by core management personnel and their close relatives, and other related entities with substantive business dealings with the target company. Related enterprises of de facto controllers and major shareholders may be preliminarily screened via the National Enterprise Credit Information Publicity System and commercial databases such as Tianyancha and Qichacha. Nevertheless, information on such commercial databases suffers from timeliness constraints and cannot replace verification conclusions obtained through official channels.

For substantive analysis of related transactions, lawyers shall focus on evaluating the commercial rationality and price fairness of relevant transactions. Detailed analysis shall be included in the report for related procurement, sales or service arrangements with prices materially deviating from fair market levels, and material impacts on the target company’s financial status shall be assessed by reference to transaction scale. Long-term large outstanding receivables owed by related parties serve as a frequent signal of fund occupation or benefit transfer. Lawyers shall require the target company to explain the causes and repayment schedules, and conduct cross-verification by referencing fund flow analysis prepared by audit institutions.

III. Professional Drafting Standards

Legal due diligence conducted by lawyers is not merely data entry work. It leverages professional legal knowledge to systematically identify latent risks that may hinder clients’ commercial activities and safeguard transaction security and reliability of commercial decisions. Accordingly, lawyers shall focus on the following prevalent issues throughout due diligence:

(I) Standards for Prudent Wording

Wording within due diligence reports directly embodies lawyers’ professional prudence and forms an important mechanism for professional risk mitigation under information constraints. Strict differentiation in expression shall be adopted according to information sources:

Information verified via official channels: “Upon inquiry…, as of the inquiry date…”;

Information solely sourced from materials provided by the target company: “Pursuant to materials provided by the Target Company…”;

Information obtained from interviews without supporting written documentation: “Confirmed by the Target Company’s management during interviews that…; the foregoing statement is not supported by written documentation.” Such information shall not be omitted from the report.

A unified risk grading system shall be established in the report’s explanatory notes and consistently applied throughout the text. Three tiers are generally adopted:

Material Risks: Risks that may block transaction progress or necessitate structural adjustments;

General Risks: Risks requiring coverage via representations and warranties or closing conditions under transaction documents;

Informational Matters: Matters with relatively limited current impact but requiring the client’s awareness and ongoing monitoring.

Descriptions for each risk point shall preferably follow the logical framework: Factual Description → Legal Analysis → Risk Impact → Recommended Measures.

(II) Limitation Statement

The limitation statement contained in the report’s explanatory notes forms a legally critical component of the due diligence report. It clearly demarcates the boundary of lawyers’ duty of care and prevents clients from relying excessively on report conclusions beyond the scope of underlying evidence. The limitation statement shall specify in detail:

The cut-off date and scope of sources for materials relied upon in this due diligence exercise;

Explanations for matters incapable of verification due to unavailability of materials or restricted inquiry channels;

Confirmation that report conclusions are based on materials supplied by the target company and publicly available information accessible to lawyers, and that consequences arising from false or omitted information provided by the target company shall be borne by the target company;

Clarification that the due diligence report does not constitute investment advice and is provided solely for the client’s reference in decision-making for this transaction.

IV. Coordination with Audit Institutions

In practice, legal due diligence is often carried out in parallel with financial audit. The two work streams are naturally complementary in information dimensions. Whether lawyers can proactively establish effective communication mechanisms with audit teams often directly determines overall due diligence quality. Abnormal fund flows identified by audit teams frequently serve as direct clues for legal issues including related transactions, fund occupation or shareholder withdrawal of capital. Large payables or long-term accrued advances may correspond to contractual performance obligations or latent disputes requiring legal verification. Contingent liabilities disclosed in financial statements generally correspond to pending litigation, arbitration or external guarantee liabilities, whose nature, scale and current handling status must be verified item by item during legal due diligence.

Lawyers shall therefore actively promote information synchronization with audit teams. At the outset of establishing coordination mechanisms, the scope of information sharing and confidentiality obligations of both parties shall be clarified. This ensures that circulation of sensitive materials complies with the client’s authorization scope and avoids additional risks of information leakage arising from coordination.

V. Conclusion

As an indispensable risk prevention tool for capital market transactions, legal due diligence can deliver full value only if lawyers uphold the duty of care, exercise professional judgment and maintain effective communication. For lawyers, the challenge of due diligence lies not only in mastering basic verification methodologies, but also in distinguishing substantial risks affecting transaction security from general information gaps within limited time and information constraints, and presenting findings in a clear and actionable manner within reports to deliver substantive professional legal support for clients’ commercial decisions. The habit of cross-verification, professional integrity requiring full disclosure, and honest articulation of limitations constitute the fundamental benchmarks demonstrating professionalism for lawyers engaged in this practice area.

Acknowledgements

Upon completion of the first draft of this article, I am greatly enlightened by Attorney Shi Jianfu from our firm, who generously shared his practical insights and experience. After repeated reflection, absorption and integration, multiple revisions and supplements have been made to the text. The current content of this article benefits substantially from his sharing. I hereby express my sincere gratitude.