Offshore Insolvency Practitioners and the People’s Republic of China

INSOL World Q1 2014, By Tim Le Cornu and Andrea Harris:

It is common practice in the People’s Republic of China (“PRC”) for companies to be part of a structure headed by an offshore holding company.  This practice provides, amongst other things, access to foreign capital via debt or equity markets outside of the PRC.  When these groups encounter financial difficulty, it is usually the providers of that capital, seeking to enforce their rights, who will turn to an offshore insolvency practitioner (“IP”) to take control of the holding company.  The IP will face unique challenges in securing assets and obtaining sufficient information from the underlying subsidiaries to understand the group’s financial position.

A joint appointment with a Hong Kong / PRC insolvency practitioner with expertise in the language, cultural and legal nuances of the PRC will mitigate these issues, deal with asset recovery and information gathering, whilst the IP will address the statutory requirements in the jurisdiction of the holding company.  In our experience, fraud may be the underlying cause of insolvency in such groups and information is crucial to enabling a full investigation into the debtor’s affairs.  This article will consider the difficulties faced by IPs, and examine the methods adopted to obtain financial information and conduct investigations.

The Enterprise Bankruptcy Law 2006 (“EBL”) was introduced in 2007 and was the first comprehensive bankruptcy law introduced in the PRC[1].  Article 5 of the EBL provides a mechanism for recognition of foreign proceedings in a bankruptcy case in the PRC.  Prima facie, the PRC Courts (“the Courts”) will consider an application where a treaty exists between the PRC and the jurisdiction of the foreign proceeding, or based on the principle of reciprocity.  Further, Article 5 requires the Courts to recognise the foreign judgement or order if it does not (1) breach the fundamental principles of PRC law, (2) impair the PRC’s sovereignty, and (3) impair the rights and lawful interests of creditors in the PRC[2].

In practice, the Courts have been reluctant to apply this Article, thus making it difficult for IPs to secure assets or obtain information from the PRC subsidiaries.  There are various factors which contribute to uncertainty regarding the application of the EBL for IPs.

The Courts have been hesitant to grant recognition, either because no treaty exists or where local creditors will not have their claims satisfied in full.  In some cases the Courts have also proven unwilling to allow assets to be sold by IPs and funds repatriated out of the PRC for the benefit of foreign creditors[3].  This is in stark contrast to common law jurisdictions which have a long tradition of comity between courts and the adoption by many countries of the UNCITRAL model law on cross border insolvency, which has significantly aided an IP’s ability to progress cross border assignments with assistance from various courts.

There have also been mixed results where the EBL has been used to seek to gain control of the PRC subsidiaries.  Petitions submitted to the Courts seeking the liquidation or reorganisation of a PRC company have been subject to significant delays due to a variety of factors.  These may include the Courts’ limited resources, relative inexperience in complex bankruptcy matters, reliance on Government direction and the case load of the Courts[4].  The Courts often take direction from government on bankruptcy applications, particularly where there are public policy grounds, for example, the potential triggering of social unrest as a result of large insolvencies.

Article 7 of the Judicial Interpretation of the EBL issued in 2011, to provide additional guidance to the Courts on the implementation of the EBL, requires the Courts to conduct a timely examination of the eligibility of the applicant to initiate bankruptcy procedures and the debtor’s cause of bankruptcy.  However, there is continuing concern amongst professionals regarding the time the Courts have taken to make decisions on EBL applications.  In one case in which we were involved, applications were made under the EBL in 2010 for the formal liquidation/reorganisation of several subsidiaries in different regions in the PRC.  Three years later we are still awaiting a decision from the Courts on the commencement of those proceedings.

Given the uncertainty whether EBL will be applied, and if so, how long this route may take, IPs will take other steps to secure assets and obtain books and records, including changing the directors and the legal representative (“LR”)[5].  Changing the LR requires the consent of the incumbent.  If he/she does not cooperate, the IPs may still need to make an application to the relevant government authority and/or the Courts, and while there is no certainty as to these types of applications the respective authorities seem more familiar with these requests and more likely to approve them.

To alleviate the uncertainties, a multi-faceted approach is often successful in such cases, particularly where fraud has led to the collapse.  The IP will engage experienced, respected PRC Counsel to navigate through the Courts’ processes, engage with the government authorities responsible for the case and at the same time seek to exert measured pressure on management for access to information.  Such pressure may include initiating proceedings through the Courts under the EBL, or other commercial or criminal remedies, depending on the circumstances.

Where the activities involve multiple jurisdictions, the IP may also consider obtaining recognition of the proceedings to facilitate investigations in jurisdictions outside the PRC in which the holding company has a presence.  Recognition may enable the IP to obtain records, and issue demands for documentation against service providers and other third parties outside the PRC, to provide information in relation to the company’s affairs.  This will often assist the IP in his investigations and/or in formulating a litigation strategy to recover assets for the benefit of stakeholders.

In a recent case we were appointed as liquidators of a Cayman Islands holding company (“the Company”). The Company, formerly listed on NASDAQ, has layers of offshore subsidiaries which ultimately controlled three PRC subsidiaries.  The proceeds of over US$600 million, raised by way of an IPO and bond issues, were purportedly invested in the PRC subsidiaries.  In the months leading up to the appointment of the liquidators, 60% of the ownership of these subsidiaries was transferred out of the control of the Company to third parties.

We faced difficulty in obtaining access to the subsidiaries’ information due to the Company’s minority ownership interest.  We filed applications in the Courts to have the share transfer invalidated and to gain access to the books and records, which remain pending.  At the same time, and to combat the uncertainty of the PRC proceedings, we applied for and were granted recognition of the Cayman proceedings pursuant to Chapter 15 of the US Bankruptcy Code.  This assistance from the US courts enabled us to obtain a large volume of records from a number of parties in the US relevant to our investigations into the activities of the PRC subsidiaries.

An IP will find it difficult to obtain remedies for entities in the PRC which form part of a wider structure and the reluctance by the Courts to apply the EBL can create further uncertainty.  These uncertainties can be aided by using a multi-faceted approach, including traditional remedies, whilst the outcome of court proceedings are pending.