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Properly handling debts of target enterprises in foreign invested Mergers and Acquisitions (M&As) is critical because the interests of all parties concerned and employees of target enterprises are closely connected to this issue. As foreign invested M&As can be divided into “Share-Rights M&As” and “Assets M&As”, it is important to understand the principle guiding debt disposal in each respective form.
Ⅰ.) The Principle behind Share-Rights M&As
According to the Rules on Foreign Investors' Mergers and Acquisitions of Domestic Enterprises (hereafter referred to as the Rules), if a foreign investor merges and acquires a domestic enterprise through a share-rights M&A, the foreign-funded enterprise established after the M&A shall inherit the debts and creditor’s rights belonging to the target enterprise.
In practice, there are two methods of pursuing share-rights M&As. One refers to a foreign investor directly buying share-rights from shareholders of the target enterprise. The other refers to a foreign investor buying the increased capital and additional shares of the target enterprise. The first method only changes the make-up of the shareholders of the target enterprise. The second one increases the paid-up capital of the target enterprise and changes the number of shareholders. Legally, both methods do not change the nature of the target enterprise and do not create a new entity. So, why do the Rules use the word “inherit”? In China, the setup of domestic-funded enterprises is regulated by the Company Law while the setup of foreign-funded enterprises is not. After share-rights M&As, the target enterprises (domestic-funded enterprises) turn into foreign-funded enterprises and then the foreign-funded enterprises inherit the debts and creditor’s rights once belonging to the target enterprise. Thus, while legally there is no change in the nature of the enterprise or formation of a new entity from this process, this metamorphosis does alter the laws which govern the enterprise.
Ⅱ.) The Principle behind Assets M&A
The Rules provide that if a foreign investor merges and acquires a domestic enterprise through assets M&A, the debts and creditor’ rights existing before the M&A shall still belong to the target enterprise.
According to this provision, the target enterprise shall still bear its debts[1] when it sells its assets. Therefore, many people wonder whether the target enterprise may lose its ability to clear its debts after it sells its assets to a foreign investor. This kind of concern is actually quite unnecessary. The target enterprise may obtain a large sum of benefits from selling its assets. Benefits arising from the disposal of the assets in such a way shall be pooled into a special capital accumulation fund. According to the Company Law, this fund shall not be used to make up any defici[2]t the company is facing. Thus, as long as detailed and strict capital evaluation and market pricing have been duly conducted in foreign invested M&As, it is impossible for a target enterprise to lose its ability to clear its debts.
Pursuant to the Contract Law, a debtor doesn’t need to gain approval from the creditor, or even notify the creditor when he sells his assets. However, this provision is unfair to creditors and cannot fully protect their rights and interests. Thus the Rules seek again to balance out the situation. They specify that the target enterprise involved in a foreign invested M&A shall send a written notice to the creditors, as well as publish a note on a newspaper with nationwide circulation 15 days before the foreign investor submits relevant documents to the examination and approval authority.
Ⅲ.) The Principle of Consultation
Apart from those two principles mentioned above, debt issues can also be solved through consultation. The Rules prescribe that foreign investors, target enterprises, creditors and other parties concerned may reach agreements on how to handle the debts of target enterprises. The agreements shall be submitted to the examination and approval authority and shall not be the source of losses of any third party’s interests, nor of any public interests.
This provision allows parties concerned in foreign invested M&As to handle debt issues flexibly. For example, if a foreign investor wants to change its creditor rights into assets, it may reach an agreement with the target enterprise, in which the investor may agree to clear the debts for the target enterprise and in return the investor may buy the assets of the target enterprise at a relatively low price, as long as no law has been violated and no other’s interests have been damaged.
[1] Debt refers to an amount of money borrowed and owed by one party to another.
[2] Deficit refers to a situation in which liabilities exceed assets, expenditures exceed income, or losses exceed profits.
