Insolvency in relation to Offshore Holding in PRC

Background Info

The People’s Republic of China (“PRC”) is a major destination for foreign direct investment (“FDI”). The PRC has implemented the majority of its World Trade Organisation commitments including relaxing investment regulations and opening a wide range of industries to foreign investments. Most of the FDI is invested through companies incorporated in offshore jurisdictions, including Cayman Islands (“Cayman”) and British Virgin Islands. More than 60% of FDI inflow to PRC is focussed on the manufacturing sector. As a result, most of the PRC insolvency assignments relate to the manufacturing sector.

Offshore holding structures are popular with foreign investors in PRC due to:

1. Preferences of offshore regimes and processes;

2. Unfamiliarity with or wish to avoid PRC’s legal and regulatory systems; and

3. Tax planning and benefits

Investment Vehicles in PRC

Common foreign investment operating structures in PRC are:

1. Investing directly (“Direct Investment”) – the foreign investors directly hold assets in PRC through an offshore company.

2. Representative office (“RO”) – is merely an extension of a foreign company. It cannot engage in any direct profit making activities.

3. Wholly Owned Foreign Enterprise (“WOFE”) – is a separate legal entity formed in PRC with foreign capital and the foreign investor has the full management control.

4. Equity Joint Venture – is an entity where foreign and PRC investors jointly provide capital contributions and the investors share risks, losses and profits proportional to their contributions

5. Cooperative Joint Venture – is formed based on a contractual agreement between PRC and foreign investors and they share risks, losses and profits in accordance with arrangements as agreed.

Legal Representative

The concept of legal representative is important in PRC. A legal representative is an individual with board powers and unlimited liability. A legal representative of a WOFE / Joint Venture (“JV”) is appointed by the members in accordance with the Articles of Association. Such appointment is required to be registered with Administration for Industry and Commerce (“AIC”) in order to effect the appointment. The legal representative exercises rights of and assumes obligations on behalf of the WOFE / JVs. The behaviour of the legal representative is deemed as the corporation’s behaviour where he / she purports to act on behalf of the corporation.

In a distressed situation, appointment of Liquidators as the legal representative of the WOFE / JV is a crucial step in order to take control the assets in PRC.

Controlling Distressed Assets in PRC

The options available to the foreign investors in controlling the distressed investments in PRC largely depend on the holding structure of the PRC entities / assets.

1. Direct Investment / RO

The most straight-forward option in order to take control of PRC assets under these two structures is to change the directors of a holding company when all directors are cooperative. However, in a distressed situation, such cooperation is rare. Appointment of Liquidators to the offshore holding company is necessary. A notarization of the appointment documents, including the appointment order granted by the offshore Court by a China Appointed Attesting Officer, will be required in order to obtain the recognition of the appointment in PRC. There are currently no reciprocal treaties between BVI / Cayman and PRC in respect of
such appointments. Subject to the PRC government administration authorities, a PRC legal opinion in respect of the appointment may also be required. Thereafter, the Liquidators will be able to control the assets in PRC.

2. WOFE and JV

WOFE and JV are the most popular structures used in the manufacturing sector in PRC. Appointment of Liquidators in place of the current legal representative of the WOFE / JV will be required in order to take control of the company. The first step is to pass a member’s resolution of the WOFE / JV pursuant to the companies’ Articles and Association. An application in respect of the registration of the appointment will then be filed with AIC. The Liquidators will need to submit the notarized appointment Order together with the company chop and the business license of the WOFE / JV to AIC.

In the case of a JV, the change of legal representative will require the cooperation of the PRC investor. In the event that the PRC investors do not cooperate or the Liquidators cannot take control of the company chop and business license, an application with the PRC Court will be necessary.

In some circumstances, bankruptcy of a WOFE / JV in PRC may be beneficial as the preservation orders over assets (by creditors) will be released thereby improving the return to the other creditors and all legal proceedings against the WOFE / JV in PRC will be stayed.

Pursuant to the PRC New Enterprise Bankruptcy Law (“New Law”), a bankruptcy petition can be made to the PRC Court by the company and creditors. The PRC Court shall decide whether to accept the petition within 15 days. The acceptance of the petition by the PRC Court does not mean that the company be ordered bankrupted. An Independent Administrator will be appointed to assess the possible bankruptcy, manage the affairs of the company and prepare a reorganisation plan (if possible).

The New Law requires the Administrator prepare asset realisation and distribution plans and submit them at a creditors’ meeting for discussion and adoption. Unless otherwise agreed by creditors, the Administrator is obliged to dispose of assets by auction. The New Law provides that secured creditors have priority over assets pledged to them by the company and allows secured creditors to claim any shortfall suffered after realising the secured assets as ordinary creditors. The distribution plan adopted at the creditors’ meeting should be submitted to the PRC Court for approval and then carried out by the Administrators once approved.

The company may be bankrupted by the PRC Court where the company cannot meet its obligations for repayment of debts due and is obviously unable to repay its debts and the liabilities of the debtor exceed its assets, or the Administrator is unable to prepare a reorganisation plan in respect of the company, or such a plan is not approved by the creditors, or the company fails to implement the plan.

The above have outlined the general overview in respect of the options available to the foreign investors or creditors for the distressed investment in PRC. A more specific plan will be needed in order to address the issues arise from difference circumstances.

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