Jurisdiction - China
Reports and Analysis
China – Will The Courts Grant “Back Door Recognition” To Overseas Insolvency Practitioners?

28 January, 2015

 

 
On 11 June 2014, the Supreme People’s Court of the People’s Republic of China (“PRC” or “China“) handed down its ruling in the case of Sino-environment Technology Group Limited (“Sinoenvironment“) v Thumb Env-Tech Group (Fujian) Co., Ltd (“Thumb“). The Court found in favour of the liquidators of Sino-environment, a Singapore incorporated company, against its wholly-owned subsidiary, Thumb, represented in the action by a legal representative that the liquidators of Sino-environment had sought to replace.
 
In making its judgment, the Court gave its view on two issues with potentially far-reaching implications for offshore creditors and investors seeking to enforce their rights in the PRC by:
 
  • recognising the authority of foreign insolvency appointees to act on behalf of the company to which they are appointed; and
  • confirming that the sole shareholder of a wholly foreignowned enterprise (“WFOE“) has the power to remove and replace the legal representative of the WFOE and that from an internal perspective, such appointment should be seen as effective from the date of the resolution, even if the changes have yet to be registered with the company registration authority, the Administration of Industry and Commerce (“AIC“).
 
However, these key decisions may not be as helpful or farreaching as they might appear at first glance, on account of certain legal and practical limitations. In this article, we outline the principles and substance of the judgment and its implication in both the short term and the longer term.
 
Background
 
The Sino-environment case is one of a number of legal actions instituted in the PRC between Sino-environment and its subsidiary, Thumb, as part of an ongoing battle for control over Thumb between the offshore insolvency practitioners appointed to Sino-environment and the incumbent management of Thumb.
 
Sino-environment was placed into judicial management by the Singapore court on 4 June 2010, following which Thumb commenced an action to compel Sino-environment to pay outstanding capital contributions to Thumb. Sino-environment paid certain amounts, but an outstanding balance remained for which Thumb was pursuing Sino-environment. On 31 May 2012, Thumb obtained an order freezing the assets of Sinoenvironment, including a RMB 45m deposit.
 
In parallel with these developments, on 20 January 2011, the judicial managers of Sino-environment passed written resolutions to replace the existing legal representative and directors of Thumb after which on 30 March 2012 (following a change of the judicial managers) further resolutions were passed appointing representatives of Borrelli Walsh as legal representative, chairman and directors of Thumb. On 11 January 2013, Sino-environment was placed into formal liquidation by the Singapore courts.
 
The role of legal representative is particularly key in the PRC as this is the individual that has the statutory power to act on behalf of and bind the company, even when acting without board or shareholder authority, except where the counterparty knew, or should have known, that the legal representative was acting without authority. As a matter of PRC law, the sole shareholder of a WFOE has the right to remove and replace the legal representative by written resolution. However, it is unclear whether this replacement is only effective when the application for changes is registered by the relevant AIC (which can require the submission of documentation by the incumbent legal representative), or when the resolution is passed.
 
As such, notwithstanding the resolutions passed by the judicial managers and a first instance court decision on 17 September 2013 confirming the validity of the appointing resolutions and requiring Thumb to register the relevant changes, the legal representative registered at the AIC remained aligned with incumbent management (a new legal representative having been appointed on 18 December 2012, after both sets of resolutions had been passed by the judicial managers).
 
The registered legal representative continued to pursue Sinoenvironment for payment of outstanding capital contributions, while in parallel Sino-environment pursued a number of actions seeking to compel the existing management and local AIC to recognise the appointment of the new legal representative. In the capital contributions case, the Fujian Higher Court concluded that the authority of the legal representative registered with the AIC would prevail and that accordingly Sino-environment was obliged to make capital contributions to Thumb. Sino-environment appealed this decision to the Supreme Court.
 
Judgement Of The Supreme Court
 
The Supreme Court dismissed the claim by Thumb for payment of capital contributions by Sino-environment. In reaching this decision, the Court focused on three key points:
 
a) That under Chinese law the power to represent a party in litigation in China was a matter for determination under the law of the jurisdiction of incorporation of the respective company. Sino-environment was a company incorporated in Singapore and had been placed into judicial management and then later liquidation by the Singaporean courts. Accordingly, given that Singapore law granted the judicial managers and liquidators the power to represent Sinoenvironment in proceedings, this would be sufficient for them to represent Sino-environment in PRC litigation. Equally, the authority to represent Thumb in the same proceedings would be a matter of PRC law, meaning that for the purposes of PRC civil procedure, it was sufficient for the company seal of Thumb to have been affixed to a power of attorney under which the claim had been filed.
 
b) That for the purposes of third parties dealing with a PRC company, the incumbent legal representative registered with the AIC would prevail over the legal representative appointed by the judicial managers but not yet registered.
 
c) However, as an internal matter between the company and its shareholders (and possibly by extension as between the upcoming legal representative and other incumbent officers such as directors and other senior managers), a valid resolution for the removal and appointment of the legal representative passed by the shareholder should prevail and have the legal effect of changing the legal representative for internal purposes. This made the resolution binding on Thumb, which in turn meant that Thumb could not pursue its claim for capital contributions against Sino-environment in the face of clear opposition from the legal representative, on the basis that the claim could not represent the true intent of the company, as embodied by the legal representative.
 
The decision made by the Supreme Court seems to make clear two things: first that the authority of foreign insolvency appointees to act on behalf of the company to which they are appointed should be recognised in the PRC provided that they have such powers under the laws of the jurisdiction of incorporation of the offshore company, and second, that a sole shareholder of a WFOE has the power to remove and replace the legal representative of the company and that such a resolution will be binding on the company for internal purposes absent registration with the AIC, and vis-à-vis third parties following registration.
 
Uncertainty In Practice
 
While the decision is clearly helpful to offshore stakeholders in PRC companies, it remains to be seen whether in practice this case will have a significant and immediate effect or whether it is merely a small step in the right direction.
 
A key issue is that while the decision comes from the PRC’s highest court, the PRC is a civil law based system without a doctrine of binding judicial precedent. Whilst Supreme Court decisions are not technically binding on lower courts, in practice they are highly persuasive and are likely to be followed by local courts in the PRC. It is however possible that there may be a level of inconsistency of approach across a jurisdiction as broad and diverse as the PRC. This could be influenced by issues such as the level of experience or competence of judges, or could even be a conscious decision to ignore the ruling when it does not suit powerful local political interests. This could leave offshore insolvency officers having to pursue a lengthy litigation process to reach a level of court where their authority might be recognized.
 
Recognition Of Insolvency Officers
 
The PRC has not acceded to the UNCITRAL Model Law on Cross Border Insolvency which provides for broad recognition of insolvency proceedings. The PRC law on recognition of cross-border insolvency proceedings is set out in Article 5 of the People’s Republic of China Enterprise Insolvency Law (the “PRC Insolvency Law“), which states that where an application or petition is submitted to the People’s Court for recognition and enforcement of a judgment or ruling of an overseas court relating to insolvency cases which have become legally effective and which involve debtors’ assets within the territory of the People’s Republic of China, the People’s Court shall, in accordance with international treaties to which China has acceded or concluded by the People’s Republic of China, or on the basis of mutuality, issue a ruling to recognise and enforce such judgment or ruling, subject to the People’s Court finding, after investigation, that such judgment or ruling does not breach the fundamental legal principles of the laws of the People’s Republic of China, does not damage China’s sovereignty, security or social public interest, nor does it damage the lawful rights and interests of creditors in China.
 
The Supreme Court in the Sino-environment case did not make reference to Article 5 and limited itself to expressing a view on the authority to bind a company as being a matter of the laws of its own jurisdiction of establishment. This falls short of full recognition of overseas insolvency, perhaps intentionally so as to avoid expanding the scope of Article 5 in a case that fell outside one of the PRC’s limited number of bilateral recognition treaties.
 
It should, however, be noted that this was not a case where formal recognition was being sought, which would typically berequired where the insolvency officer was seeking the assistance of the local courts in collecting in assets or granting the overseas insolvency officer with statutory or other powers. As such, the impact of the judgment may seem limited in an insolvency context.
 
Equally, the fact that the decision is not based on the recognition of insolvency proceedings could mean that it could have broader application. By way of example, receivers and managers of a company would not typically enjoy recognition as insolvency officers, but could argue that when appointed under a debenture governed by the laws of the jurisdiction of incorporation, that their authority to act on behalf of the company should be recognised as their rights are recognised under the laws of such jurisdiction. This interpretation would be consistent with the strict reading of the decision of the Supreme Court, although in practice difficulties may be encountered due to the distinction between receivers as creatures of contract, compared with insolvency officers appointed by the Court. Under the PRC Insolvency Law, only the latter are recognised. An assertion of authority to act on behalf of an offshore company would likely be more powerful and more likely to be recognised by a risk-averse PRC judge when supported by a court order confirming the authority of the representative to act. Such an order would not typically be sought or obtained on a receivership, unless the company challenges the appointment and is defeated.
 
One key point to note is that the Supreme Court focuses on the authority of a liquidator from the jurisdiction of incorporation. This means that a liquidator appointed in a different jurisdiction (such as on the winding up of an overseas company which has sufficient connection to a jurisdiction) would not have the benefits that a home jurisdiction liquidator would enjoy in PRC proceedings. This may also have an impact in cases where there has been forum shopping, with a company moving its centre of main interests to take advantage of a more favourable insolvency regime.
 
Ability To Take Control Of Onshore Subsidiaries
 
The key reason that offshore insolvency officers would typically wish to have their authority recognised is to be able to take control of the business of the onshore subsidiary. As noted above, the key individual with authority to act on behalf of a PRC company is the legal representative of the company.
 
It is the shareholder of the company which typically has the power to appoint and remove the legal representative. In our experience, it has generally not been straightforward for insolvency appointees to offshore shareholders to exercise this power onshore. The reason for this is that, as acknowledged by the Supreme Court, for third parties the identity of the legal representative will be the person who appears in the registry of the AIC, regardless of what resolutions might have been passed by the shareholder. As such, the key practical hurdle for the shareholder to overcome is registration with the AIC.
 
A key point to note is that the Sino-environment case deals with the specific circumstance of a dispute between a company and its shareholder. For this reason, the Supreme Court draws the distinction between the internal and external authority of the legal representative. While the judgment is helpful in confirming the internal authority of the new legal representative, it does not, on its own, assist the new legal representative in dealings with third parties. It is this power to deal with third parties which will be crucial to taking control of the business of the subsidiary and, as stressed by the Supreme Court, third parties should still consider that authority as residing with the legal representative that appears on the AIC register.
 
AICs operate on a local level and practices can vary along with the level of sophistication of the relevant AIC. Certain AICs may recognise the authority of the shareholder alone to change the identity of the legal representative and process an application accordingly, while others may rely on the authority of the outgoing legal representative and so require signed evidence of resignation from the outgoing legal representative to process their removal. This can obviously prove problematic where the incumbent legal representative is not co-operative (which will often be the case in a distressed situation) and where a signed resignation has not been obtained in advance or if the incumbent legal representative seeks to challenge or repudiate a pre-signed resignation. In addition, AICs will often require the application to be stamped with the company chop or seal, which would typically remain in the custody of the incumbent legal representative and so will not be available for this purpose.
 
The fact that the Supreme Court reinforces the power of the shareholder to replace the legal representative is helpful. However, the practical effect of this may be limited if individual AICs do not follow the decision and update their practices to remove the requirement for the outgoing legal representative to consent to their own removal. In this regard, we note that AICs may take the view that as no AIC was party to the Supreme Court judgment, it would not be directly applicable to them. If AICs retain formal requirements that the offshore shareholder cannot practically deliver, the offshore shareholder will be left having to pursue the replacement of the legal representative through the courts. As seen from the various claims made by Sino-environment against the Company, its incumbent directors and the relevant AIC, that this can prove to be a long and uncertain process. Sinoenvironment obtained a decision of the intermediate court on 17 September 2013 in a claim against Thumb and representatives of incumbent management that the replacement of the legal representative was valid and that Thumb should complete the relevant filings within 10 days. Despite this ruling, the changes remained unimplemented.
 
Accordingly, if AICs are not willing to take a more flexible approach to accepting the registration of new legal representatives, there would likely be significant delay for offshore shareholders as they pursue litigation to compel the AIC to recognise that registration. This is not to say that the Sino-environment judgment will not have any effect. As noted above, the existence of the Supreme Court judgment will be highly persuasive to courts considering claims and may serve as authority for some courts to side with the offshore shareholder. At the very least it can be cited in legal argument in trials across China.
 
Conclusion
 
The Sino-environment judgement is not likely to result in an overnight sea-change in the PRC and does not mean the PRC authorities will start recognising the authority of offshore insolvency appointees of shareholders to the point where they can routinely remove recalcitrant legal representatives and exert control over their onshore subsidiaries.
However, the judgment sends a clear signal from the highest level of the PRC judiciary that it recognises the powers and role of offshore shareholders under local law in the jurisdiction of appointment and will respect those powers.
 
In a jurisdiction as large and diverse as the PRC it is not realistic to expect immediate change on a local level nationwide absent an express change in the law, or an official judicial interpretation of the legal provision governing changes to the identity of the legal representative, but the decision would seem to be a strong and clear step in the right direction, which, over time, will filter down to change local level practice, as part of a broader opening up of the PRC to, and recognition of, international insolvency practices.
 
Hogan Lovells
 
For further information, please contact:
 
Stuart Tait, Partner, Hogan Lovells
stuart.tait@hoganlovells.com 
 
Andrew McGinty, Partner, Hogan Lovells
andrew.mcginty@hoganlovells.com
 
Chris Dobby, Partner,Hogan Lovells
chris.dobby@hoganlovells.com 
 
 

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