The ongoing COVID-19 pandemic has a devastating impact on businesses of all kinds worldwide. Some companies will eventually be forced to initiate insolvency proceedings. If a German company has direct investments in China, the question is, how their Chinese entities are affected by the German insolvency proceedings. With regard to Chinese entities it is essential to have a look into the insolvency law and legal practice of the People’s Republic of China ("PRC") and understand its legal framework as well as the specific regulations on cross-border insolvency and the recognition of a German insolvency judgment or court order ("Gerichtsbeschluss").

Since the German parent company and its PRC foreign invested enterprises are separate legal entities, the insolvency of the parent company does usually not automatically trigger the insolvency of its affiliated companies in the PRC.

For each subsidiary located in the PRC it will thus have to be checked individually how to proceed in case of insolvency of the parent company. If the preconditions for insolvency in the PRC are met, the insolvency procedures for the Chinese entity will commence according to the relevant PRC laws. In practice, the insolvency of the German parent company often also entails the insolvency of the Chinese subsidiaries, since the subsidiaries are usually highly dependent on the existence and operation of their parent company due to their business model and practices.

As long as the Chinese entity still exists, its shares/equity become insolvency assets which may be used to pay the parent company’s creditors in Germany.

After a German company has commenced insolvency proceedings, an insolvency administrator will be appointed by the German insolvency court. From the moment of appointment onwards, the insolvent company (more precisely: the assets of the insolvent company) can be legally represented by that insolvency administrator only. The insolvency administrator will be responsible to gather and liquidate the insolvency assets and lawfully distribute the proceeds among the insolvent company’s creditors in accordance with the German insolvency law ("Insolvenzordnung" ="InsO"). Where the insolvent company is a shareholder of a PRC company, these shares or equity also become insolvency assets. In the course of such cross-border insolvency procedures, the recognition of decisions and judgements of the German insolvency court is essential for any legal transaction in regard to the assets the insolvent German company holds in the PRC.  

The main relevant law on insolvency in the PRC is the Enterprise Bankruptcy Law ("EBL").

It came into force in 2007 and regulates insolvency and reorganisation procedures and applies equally to any legal person, regardless of whether it is a state owned or private enterprise and whether it has Chinese or foreign shareholders. Thus, the EBL applies to all kinds of Foreign Invested Enterprises ("FIE"), such as but not limited to Joint Ventures and Wholly Foreign-Owned Enterprises ("WFOE"). Representative Offices do not fall under that law because of lack of the status as a legal person.

For a Representative Office, different laws apply and in case its related foreign company is terminated, the Representative Office is required to apply for deregistration at competent authorities within 60 days upon the date the foreign company is terminated.

Whereas the PRC law and courts’ practice used to be restrictive to grant confirmation and permit enforcement of foreign insolvency judgments, the EBL has improved the creditors’ position in respect to cross-border insolvencies. The confirmation and enforcement of any foreign final and effective judgment or court order that involves any debtor’s assets within the territory of the PRC by the PRC courts is subject to the conditions set out in the EBL and relevant laws.

The recognition of a judgement or court order of a foreign insolvency court does not happen automatically in the PRC but judicial recognition is required.

The insolvency administrator, who is representing the assets of the insolvent company, may apply to the competent People’s Court for recognition and enforcement of that foreign insolvency judgment or court order within two years after the foreign judgment/court order has become legally effective.

PRC courts will only recognize and enforce insolvency judgements or a court order related to insolvency proceedings issued outside the PRC if they can be mutually recognized through a relevant international treaty between the country concerned and the PRC China or through a reciprocal relationship between those countries.

At the moment, such treaty between the PRC and Germany does not exist. However, after the Court of Appeal of Berlin had recognized a commercial judgment issued by a Chinese court from Wuxi, Jiangsu Province, the People’s Court of Wuhan also recognized a decision of an opening of bankruptcy of the County Court of Montabaur in 2013. Since then, the principle of reciprocity can be assumed as established between Germany and the PRC.

According to the relevant laws, the People’s Court will refuse recognition if formal aspects are not fulfilled, e.g. legal effectiveness or enforceability of the judgement or court order, competence of the foreign court, proper legal representation of the losing party. The recognition of the judgement or court order will also be refused if there is a pendency of the case with a PRC court. Furthermore, the PRC court will only grant recognition, if the foreign decision neither violates the basic principles of the Chinese legal system nor harms the sovereignty, security and society’s interests of China, and if recognition and enforcement of that foreign decision will not damage the legitimate rights and interests of the creditors within the territory of the PRC. The broad wording of the latter aspects leave a wide discretion to the PRC courts when deciding on the recognition.

If the before-mentioned conditions are fulfilled and the German insolvency judgement or court order has been recognized by the PRC court, the following procedure depends on the shareholding structure of the Chinese corporation.  

A WFOE may have one or more foreign shareholders. For a WFOE that consists of a sole German shareholder and if insolvency proceedings have commenced in Germany against such shareholder, the insolvency administrator who represents the shareholder may resolve to dissolve and liquidate the WFOE. Often in practice, the shareholder will hardly find a new investor for that WFOE, since the business operation of the WFOE is usually strongly connected and depending on its German parent company.

Similarly, for a WFOE that consists of multiple foreign shareholders of which a German shareholder is insolvent, the insolvency administrator may propose to adopt the afore-mentioned resolution to liquidate the WFOE. It will subject to the vote of the shareholders’ meeting whether such resolution can be passed. Alternatively, the insolvency administrator may sell its shares or equity in the WFOE, in which case the other shareholders shall have a statutory pre-emption right to purchase such shares or equity. The remaining assets (if any) distributed to the shareholder after lawful liquidation become insolvency assets for the creditors in Germany/abroad.

A Sino-German Joint Venture ("JV") consists of two or more shareholders from the PRC and other countries. The Articles of Association ("AoA") of such JV typically contain a call option clause. Such clause entitles the other shareholder(s) to call and purchase all or any part of the insolvent shareholder’s equity interests in the JV in case one shareholder has become insolvent. Where the call option right is not exercised by the other shareholders, the shareholder represented by the insolvency administrator may sell the equity interests to a third party. In this case, the other shareholders are entitled to a statutory pre-emption right. The AoA may further entitle the insolvent shareholder to terminate the JV, which means the JV will be dissolved upon an according resolution of the board of directors. In that case, the remaining assets (if any) of the insolvent German company as shareholder of the JV distributed from the Chinese corporation in the course of the dissolution become insolvency assets.

Under all circumstances above, the insolvency administrator may wish to propose the dissolution of the company for practical reasons, e.g. to prevent continuation with a third party as shareholder or because he simply cannot find a new investor, or because the insolvency of the parent company would prospectively also lead to the insolvency of the PRC entity due to commercial reasons.

If another shareholder of the JV exercises its pre-emptive right or if the insolvency administrator has found a new investor to purchase the shares or equity of the Chinese entity from the German parent company, a share purchase agreement ("SPA") is to be signed upon approval of the creditors committee, together with other relevant formality documents which are to be submitted to the relevant PRC authorities, as required by the PRC laws.

During such transaction, the German parent company, as the seller of its shares or equity, must be legally represented by the insolvency administrator. Such transaction is only possible if the insolvency judgement of the German court has been recognized by the relevant PRC court; otherwise the insolvency administrator would not be legally recognized as the authorized representative to execute documents related to such transaction.

Key steps following the conclusion of the SPA include the transfer of the shares from the parent company to the other shareholder or new investor and the payment of the purchase price.

According to a guideline released by the PRC Supreme People’s Court in 2018 ("Minutes of the Conference on Bankruptcy Trials Heard by Courts in China"), after the People’s Court has recognized the judgment or court order of the bankruptcy case made by a foreign court, the order of priority for payment out of the debtor’s assets will firstly be domestic secured creditors, followed by employee wages, social insurance and tax owed etc., and then finally the remaining assets of the debtor can be assigned in accordance with the requirements of the foreign court.

Finally, the purchase price will be transferred to Germany, where the insolvency administrator will use it to satisfy the parent company’s creditors.

When transferring the purchase price for a typical SPA, the bank will require some standard formalities as the conditions to release the purchase price to the overseas shareholder. Typical documents include the application form for outbound remittance, tax filing form for outbound payment, copy of the executed SPA and copy of updated business license etc. However, for an insolvent shareholder, additional documents are highly likely to be required since the purchase price will be released to the insolvency administrator in Germany, which means the recipient’s name will not match the insolvent shareholder’s name recorded at the bank. In this case, both the bank and PRC foreign exchange authority may ask for further supporting documents in order to verify that the insolvency administrator is legally authorized to be the recipient of the purchase price.  

Insolvency procedures are generally a complex matter. Where a cross-border component is added to the national procedure, more legal, economic and practical questions arise. In order to ensure satisfaction of the insolvent company’s creditors, as well as a lawful and smooth execution of the cross-border insolvency procedures between Germany and the PRC, legal advice and assistance is strongly recommended. With our established China and Insolvency Practice in Germany and China (Shanghai) we are happy to assist in such cases.

Germany:
Dr Bjoern Etgen, Munich
Christian Fuhst, Munich
Ansgar Hain, Berlin

Shanghai:
Patrick Heid, LLM.
Li, Kerui, LL.M.
Maria Kieslich