Foreign Investment

After the acquisition of undisclosed foreign debt that who will bear?

Who Shall Bear the Undisclosed Debts of the Target Company?

Min Cho

 

Case Brief

Guangdong XX Technology Ltd. Co. (short for Target Company) is a domestic company set up and registered inGuangzhou. The shareholder A of the Target Company reached an equity transfer contract with a British company B. A agreed to assign 100% share of the Target Company to B. Additionally, A and B concluded a separate agreement on disposition of Target Company’s debts incurred before equity acquisition. Both party agreed that “debts of the Target Company incurred before equity acquisition and having been disclosed to B in written form (disclosed debts) shall be borne by the Target Company after acquisition. However, debts of the Target Company incurred before equity acquisition but having not been disclosed to B in written form (undisclosed debts) shall be borne by A only after acquisition. B and the Target Company shall be exempted from bearing the undisclosed debts.” After approval by relevant competent authorities, in October 2008, A successfully transferred 100% share of the Target Company to B with the result that the Target Company was changed to be a foreign-invested company. Subsequently, the Target Company received an attorney letter from a company C stating that the Target Company shall pay money to C for its taking delivery of goods from C in 2007. C required to be paid within 15 days; otherwise it would file a lawsuit against the Target Company. B alleged that A did not disclosed the Target Company’s debt owing to C during the equity acquisition, so according to the agreement between A and B, this undisclosed debt shall be assumed by A. B refused to pay C by the Target Company.

 

Legal Opinion:

In this case, in order to be exempted from bearing the undisclosed debts, A concluded a debt disposition contract with B agreeing that any debt of the Target Company beyond the disclosed debts shall be borne by A. I think that, according to the Civil Law and the Company Law, the Target Company is an independent legal entity. Equity transfer (change of shareholder) does not exempt the Target Company from assuming its own debts. The debts disposition agreement is only binding on A and B rather than on the creditors of the Target Company. All creditors (including the creditor of undisclosed debts) are entitled to claim for compensation against the Target Company; while the Target Company is obliged to pay the debts. After the Target Company fulfills its obligation of payment to C, B will get the right of recourse against A according to the debts disposition agreement.

Noteworthy, Article 13 of Provisions on M&A of a DomesticEnterpriseby Foreign Investors (No.6 Decree of MOFCOM, 2009) sets forth that “where a foreign investor carries out equity merger, the foreign investment enterprise established after the merger shall succeed to the claims and debts of the merged domestic company…… The foreign investor, the merged domestic enterprise, the creditors and other parties may reach an agreement additionally on the disposition of the claims and debts of the merged domestic enterprise, provided that the agreement shall not damage a third person's interests or public interests. The agreement on disposition of the claims and debts shall be submitted to the approval authority.” I don’t think this prescription imposes upon the merged company’s creditors binding force of the debts disposition agreement concluded between the equity transferor and transferee. Actually, this article is designed for the purpose of bringing more flexibility to merger and acquisition. For example, the foreign investor could purchase the equity at a lower cost provided it promises to assume part of the merged company’s debts. Therefore, it is not correct to refuse to pay to the creditors by citing Article 13 of the Provision.