Piercing the Corporate Veil: SPC Provisions Offer Hope for Creditors in Enterprise Restructuring

SOE reform has assumed greater urgency in recent years for several reasons. Non-performing loans racked up by SOEs are a millstone around the neck of China's state banking system, and a drain on the Chinese economy generally. China cannot continue to ignore this problem. In addition, a key communist party policy calls upon Chinese government regulatory authorities to divest themselves of their SOE protégés in order for China to satisfy its obligations as a WTO member and create a bona fide market economy. China is obliged as a WTO member to stop subsidizing and protecting SOEs. The solution, it seems, is to institute a "modern enterprise system" (現代企业制度) by transforming SOEs into limited liability companies and joint stock companies under the provisions of the PRC Company Law (中华人民共和国公司法)(the Company Law). It is hoped that the restructuring of SOEs into Company Law companies will effect a separation of government from enterprise administration (政企分开) and rationalize corporate governance.

Company Law companies have several distinctive legal features that greatly appeal to Chinese government policymakers. They potentially offer improved management and oversight via Western-style corporate governance structures. Unlike SOEs, in which a factory director is only answerable to various government regulatory authorities, power in limited liability companies and joint stock companies is divided among a board of directors, a shareholders' committee and a supervisory committee. More importantly, in contrast to SOEs for which Chinese government owners are ultimately responsible, Company Law companies are endowed with limited liability. For financially strapped Chinese government departments, limited liability affords a convenient way for government owners to be free of substantial financial commitments.

Notwithstanding the obvious appeal to the Chinese government of restructuring SOEs into Company Law companies, it has heretofore been administratively cumbersome to push through SOE restructuring proposals. Typically, multiple administrative authorities have conflicting vested interests in SOE restructurings. In the context of China's approval system, it is relatively easy for a particular administrative authority to stymie a reform proposal that is deemed contrary to its interests.

Fortunately, the government has been moving quickly to clear away various ideological and administrative obstacles blocking the path of SOE reorganization. On the ideological front, China is preparing for privatization by debating changes to the PRC Constitution, which would legitimize the wealth of China's "super rich" class (暴富阶层). (This move comes notwithstanding the fact that much of their wealth was misappropriated or obtained by corrupt means, a fact that some members of the super rich are confident enough to openly acknowledge.)

On the administrative side, on May 27 2003 the PRC State Council issued the Supervision and Administration of Enterprise State-owned Assets Tentative Regulations (the SOE Regulations). The SOE Regulations form, in part, the basis for the quasi-privatization of Chinese state-owned enterprises. Article 6 of the SOE Regulations provides that the State Council, and people's governments at the provincial, autonomous regional, municipal and autonomously administered county (自治州) levels shall each establish state asset supervision and administration organs (SASACs). These SASACs will be authorized to undertake the responsibility of investors in supervising enterprise state assets. An important function of the SASACs is to consolidate approval authority for SOE reorganizations into a single administrative authority.

The Provisions represent a similar effort to facilitate enterprise restructuring (and implicitly the privatization process) by placating creditors. Creditors form another lobby whose interest conflicts with SOE restructuring. State banks, especially, are often frustrated by SOEs repudiating debts via the restructuring process.

The Provisions

The Provisions are important since they replace the dominant legal principal of "creditors' rights follow the principal" with that of "creditors' rights follow the assets".² Under the Provisions, in limited circumstances creditors may recover from multiple parties.

Chinese state banks have always viewed the restructuring of SOEs with considerable trepidation, since PRC law heretofore has made it very convenient for debtors to repudiate debts to state banks by undergoing restructuring. This was a chief concern of China's asset management companies three years ago at the time the regulations for administering these companies were being drafted. At that time, SOEs commonly referred to SOE restructuring plans (principally by debt-for-equity swaps) as "the last free supper" (最后免费的晚餐), mocking the restructuring proposals as an opportunity to benefit from another state bailout. The Provisions appear to be an attempt to provide legal protections to creditors in the restructuring process.

Article 1 of the Provisions provides that people's courts shall accept cases involving the following situations:

1. civil disputes arising during restructuring of enterprises as companies;

2. civil disputes arising during restructuring of enterprises as cooperative share system enterprises;

3. civil disputes arising during division of companies;

4. disputes in connection with debt-equity swaps of enterprises;

5. disputes in connection with contracts for the sale of enterprises;

6. disputes in connection with contracts for the merger of enterprises; and

7. other disputes in connection with enterprise restructuring.

The foregoing restructuring scenarios are common situations in which debtors attempt to repudiate debts via the restructuring process.³

Specifically excluded from the scope of people's court jurisdiction are disputes arising in the course of "administrative adjustment or re-allocation of an enterprise's state-owned assets by the competent government department".⁴

Significantly, the foregoing restructuring scenarios involve enterprises generally and are not limited to SOEs. As a result, the Provisions could also conceivably apply to foreign-invested enterprises, including equity joint ventures, cooperative joint ventures and wholly foreign-owned enterprises. Still, as mentioned earlier, given China's ongoing SOE reform programme it would seem that the objects of the Provisions are SOEs and their state bank creditors.

Creditor's Rights Follow the Assets

In China the lack of legal protection for creditors vis-à-vis enterprises undergoing restructuring has long been a source of frustration. Prior to promulgation of the Provisions, the prevailing legal principle under PRC law was that of debts follow the principal. According to the Jinrong Shibao, this system permitted debtors via restructuring to repudiate debts as easily as "a cicada sloughing its skin" (金蝉脱壳).⁵ The Provisions seek to foreclose this option by replacing the debts follow the principal precept with that of the creditors' rights follow the assets.

The creditors' rights follow the assets principle is manifest in Article 7 of the Provisions. Article 7 provides that if an enterprise uses part of its best assets to establish a new company with another party and retains debt in the original enterprise, the newly established company shall assume joint and several liability with the original enterprise to the extent of the assets received by the new company.

In a division scenario, the original enterprise and the newly established enterprise shall be jointly liable for the original enterprise's debts in the absence of an agreement concerning such debts or where the creditor in question did not approve such agreement (see Article 12). Liability shall be shared according to the asset ratio at the time of the division (see Article 13). Articles 12 and 13 would appear to be at odds with Article 26 of the Merger and Division of Foreign-invested Enterprises Provisions issued September 23 1999 (the FIE Merger and Division Provisions, revised November 22 2001) by the Ministry of Foreign Trade and Economic Co-operation (now the Ministry of Commerce) and the State Administration for Industry and Commerce. Article 26 of the FIE Merger and Division Provisions nullifies creditors' claims in merger or division situations where creditors fail to exercise creditors' rights within 30 days of written notification of merger or division to creditors, or within 90 days of public announcement of such merger or division.

In an asset purchase, Article 24 of the Provisions provides that where a buyer of a small-scale SOE injects the enterprise assets purchased into the purchaser enterprise or subsumes the purchased enterprise into a subsidiary of his own enterprise, the debts of the purchased enterprise shall be borne by the buyer.

Article 25 is especially harsh. It reads: "After the sale of an enterprise, if the buyer organizes a new company with another party by injecting the assets of the purchased enterprise as equity of a certain value and the purchased enterprise legal person is de-registered, the civil liability for the debts of the enterprise incurred before the sale shall be borne by the buyer to the extent of all of his assets, including his equity in the newly organized company." The purpose of Article 25 is to stop the common practice of manipulating the asset appraisal system by injecting high value assets into a newly established company at an artificially low value, and thereby wasting the assets of the parent debtor.

In a share acquisition situation, typically the debts of the target will remain with the target. However, the people's courts may go after the acquiring shareholder in a target where the controlling shareholder is responsible for wasting the target's assets resulting in the target having insufficient assets to repay the debt.⁶

Areas of Concern

The Provisions seem to afford creditors, particularly state banks, more legal comfort amid the ongoing restructuring of debtor SOEs. However, the Provisions may create further uncertainty for potential acquirers in M&A transactions.

First, by giving creditors the right to annul restructuring agreements or pursue debtors following a merger or division without imposing reasonable time limits for bringing a claim, the Provisions seem to undermine the integrity of Chinese government approval for the deal. In Chinese law, uncertainty and grey areas in laws and regulations have always been a problem. One of the relatively few areas of certainty in a deal is the security provided by the government's approval of a project. To the extent that the Provisions undermine that protection, transparency and legal clarity in Chinese law are diminished.

On a related note, the Provisions seem to undermine the chief benefit of undertaking an asset purchase rather than an equity purchase. Acquirers will often opt for an asset purchase arrangement in order to avoid Chinese government approvals and acquire the target assets free of liabilities as in an equity acquisition. However, the Provisions seem to nullify this benefit of asset acquisitions by enunciating the creditors' rights follow the assets principle.⁷

Finally, the Provisions are not well drafted. While it would seem that an important objective of the Provisions is to protect creditor banks vis-à-vis SOE debtors undergoing restructuring, the Provisions refer to enterprises (企业) generally and, as a result, literally may apply to all types of enterprises including FIEs. Particularly confusing is Section 6 entitled Sale of Small-scale State-owned Enterprises. Notwithstanding the heading, the articles in Section 6 again refer to enterprises generally rather than to SOEs specifically. Moreover, Section 6 concerns the "sale of enterprises"; however, it is not apparent whether such a sale refers to an asset sale or to an equity sale.

Endnotes

1 It is unclear what the legal basis is for the Supreme People's Court to issue "provisions" (规定). Typically, the Supreme People's Court will issue an "interpretation" rather than administrative regulations. See China Law & Practice, February 2003, 17(1), pp. 61-67 for a translation of the law.

2 <> 金融时报, 2003年9月25日, 第9页.

3 Ibid.

4 See Article 3 of the Provisions.

5 <> 金融时报, 2003年9月25日, 第9页.

6 See Article 35 of the Provisions.

7 See Articles 24 and 25 of the Provisions.