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What it means and what to do if a creditor files a winding-up petition against your company
 
Times are tough.  Business is down.  Your company is having difficulty paying its creditors and some of them are getting downright rude in their demands for payment.  Then one particularly disgruntled creditor hits you with the ultimate threat: "If you don't pay me by next Friday I'm going to wind you up - no more excuses!"


Should you be worried?  Can they really do that?  What does it mean?


These are all common questions directors and management of troubled companies ask when faced with the threat of a winding-up petition.  The bad news is that a winding-up petition issued and served against a China company can have a significant and negative impact on its business, and if not dealt with carefully may lead to its ultimate demise.
 
The good news is that very few significant China companies are actually ever wound-up by such creditors, as more often than not a deal is struck to avoid such a disaster (albeit after and often as a result of the filing of a petition).  Thus, whilst disruptive and dangerous, winding-up petitions are often viewed as a necessary catalyst to resolving a company's debt problems, and this is one of the main reasons why creditors file them.  The fact of the matter is that winding-up petitions force action and resolution, particularly with companies that are in a kind of malaise with their creditors - companies that spend months haggling with creditors over terms without ever taking meaningful steps to consummate a deal.  At the end of the day there is no better impetus to getting a deal done - for both sides - than the ever faster approaching date of a court hearing to determine, once and for all, the company's fate.  The court's message to both sides is the same: arrive at a deal before the hearing or face the consequences. 

Circumstances in which a winding-up petition can be issued

Generally, creditors will turn to a winding-up petition only when all other debt collection efforts have failed - after all, the amount realised in a liquidation scenario is often highly uncertain.  Indeed, experience shows that in many cases, ordinary creditors receive just a fraction of the sums they are owed.  However, before a creditor will hire a lawyer to issue and serve a winding-up petition it will usually first do its homework and make sure it has the grounds to do so.  Why?  Because if it does not, it will be on the hook both for its own legal costs and the costs incurred by the debtor in its defence of the petition.  What are these grounds?  Simply put, a creditor must have (i) an undisputed debt (ii) that is due and payable (iii) that the debtor is unable to pay.  A debt is deemed to be 'due and payable' on a specific date, e.g. under a contract, upon the expiry of a formal or statutory demand (after three weeks in China), or at the court's discretion.
 

The implications of a winding-up petition for your business

Once the petition has been issued and served, the petitioning creditor is required to advertise it in the government Gazette and at least two China newspapers - one English and one Chinese.  Your problems will now become public, and this will undoubtedly serve to increase the pressure from your other creditors and demoralise your staff.  Making the petition public may also cause another problem: your banks may 'freeze' your accounts under Section 182 of the Companies Ordinance to ensure they are not accused of dissipating the company's assets (although in practice many banks in China do not take this drastic step as it impacts significantly the company's ability to conduct business).  If your company is listed in China, once a petition is lodged you would immediately need to make a public announcement.    
 
By far the greatest threat to your company that can result from a winding-up petition being issued is that the petitioner can ask the court to appoint a provisional liquidator to the company.  A provisional liquidator would assume the powers of the company's directors.  He would also and in their place manage and preserve the company's assets for the benefit of all creditors pending the hearing of the petition.  The purpose of such an appointment is to ensure that the company's assets are not dissipated pending the making of a winding-up order. 
 
The appointment of a provisional liquidator and the attendant change in management usually has an enormous impact on a company's business.  Provisional liquidation invariably leaves a company perilously close to formal liquidation (and certain death).  The good news is that because the appointment of a provisional liquidator is such a serious step, the petitioner must present evidence to the court that the company's current directors are likely to dissipate its assets or otherwise mismanage its affairs in the absence of a provisional liquidator.  Whilst for most petitioners such evidence will be hard to come by, it is not at all uncommon for petitions to appoint provisional liquidators to be granted in reliance on little more than sworn statements from creditors alleging the debtor's bad faith in failing to answer creditors' written demands and telephone calls. 
 
Having a winding-up petition served against your company is not all bad news.  There are a few 'good things' that can arise (in addition to the 'catalyst' point mentioned above), particularly if no provisional liquidator is appointed.  One is that under section 181 of the Companies Ordinance, you will be entitled to ask the court to stay or halt all current legal proceedings commenced by parties against you until the court rules on the petition (generally, as discussed below, many weeks hence).  Another is that once a petition has been served, no other writs can be filed against your company without permission from the court. 
 
Still another advantage to having a winding-up petition filed against your company is that under section 269 of the Companies Ordinance, a creditor cannot retain the benefit of a charging order or attachment of assets unless the order or attachment has been completed before the date of the winding-up petition.  This effectively means that once a petition has been issued, creditors lose the opportunity to get a charging or garnishee order over uncharged assets or an order for a bailiff to seize the company's moveable assets (computers, furniture, equipment, etc.).  There is in effect a 'freeze' upon all legal and asset recovery efforts against your company.  The company's directors will therefore gain some valuable breathing space in which to try and sort out the company's affairs. 
 

How should you respond? 

Once a winding-up petition has been issued and served against your company, you must take it very seriously.  Ignore it and your company will most certainly be placed into liquidation by the court.  Hiring experienced financial and legal advisors is a must.  The key is to decide upon and then implement a correct response.
 
Generally, most large companies will oppose winding-up petitions filed against them if for no other reason than to buy them some time to work out a deal.  Often the first hearing date of the petition will be weeks from the initial filing.  If contested at that hearing, which is before a court master (a court official just below a judge in rank), the petition will have to be heard by a judge.  Again, getting a place in that judge's calendar can take several more weeks or even months.  Thus, at least initially, time would appear to be on your side. 
 
There are many ways to oppose a winding-up petition.  The most straightforward method is to oppose the petition on the grounds that you dispute the debt claimed by the petitioner and which forms the basis for the petition.  Recent court decisions indicate that the court will not allow the winding-up procedure to be used a tactic to put pressure on a debtor when there is a genuine dispute as to whether a debt is due.  Thus, courts will generally allow for an adjournment of the hearing to a later date in such cases to enable the debtor to put in evidence to that effect.  Only in exceptional cases will lengthy adjournments be allowed, and it would be a rare case indeed for a petition to be dismissed in such circumstances. 
 
Many China companies will have a winding-up petition filed against them by a particular creditor or group of creditors only after restructuring negotiations have reached a protracted stalemate.  Such companies will generally oppose the petition by stressing to the court that restructuring negotiations are in progress with various creditor groups, potential investors, etc. and that the majority of the creditors would prefer negotiations to continue to enable the parties to reach a settlement and avoid liquidation. 
 
Given China's lack of a formal debtor rehabilitation procedure (such as Chapter 11 in the US or administration in the UK or Australia), courts can sometimes be persuaded in such circumstances to adjourn the hearing of a winding-up petition to a later date to allow the parties additional time to conclude a consensual restructuring.  However, bear in mind that the combination of the stay that results from the issuance of a winding-up petition and any adjournments of its hearing granted by the court result in a de facto court driven restructuring process that places the fate of both the debtor and the creditors in the hands of a judge. 
 
In practice, China judges will not automatically allow for multiple and/or lengthy adjournments, and may at times place a company into liquidation for no apparent reason other than to indicate their displeasure at the lack of meaningful progress being made and thus send a message to the market that the winding-up process is to be taken seriously.
 

Getting out of trouble 

So, a winding-up petition has been issued and you have successfully secured an adjournment of its hearing.  The pressure is off, but only for a short while.  Now what should you do?  In our experience there is only one thing to do if you want to save your company and your employees' jobs: work as hard as you can to come to terms with your creditors before the next hearing, as the court may not allow you a second chance.

If a winding-up petition has been issued against your company, all is not lost.  However, as indicated above, you will have to work extremely hard and make many compromises in order to successfully challenge the petition, keep your company afloat and return it to prosperity.  Of course the best course of action you can follow when facing increasing demands from your creditors is to work with your creditors and arrive at a consensual repayment plan with them thus avoiding the prospect of ever having a winding-up petition being filed against your company.  As demonstrated above, the negatives from such a filing - from increased pressure from your other creditors, bad publicity, low employee morale, just to name a few, clearly outweigh any positives.


Companies in Europe or the US facing insolvency are often tempted to leave their Chinese subsidiaries stranded - disregarding the consequences under Chinese law. Who can afford to be banned from investing or working in China?
With the economic crisis in full swing many small and middle sized companies, often second or third tier suppliers, are now collapsing. The management has to file for insolvency and an insolvency administrator will be appointed to work out a solution for keeping the company alive or - if this is not an option anymore - to properly liquidate the company.

Surprisingly many of these distressed companies are having subsidiaries located in China. They are generally limited liability companies governed by the Chinese Company Law. The common set-up is that the Chinese subsidiary has only one customer: The parent company in Europe or in the US. In consequence, the Chinese subsidiary will be dragged down together with its parent company.


However, since all the involved parties - the management, the shareholders, the insolvency administrator - are busy dealing with the mother company, its creditors, customers, potential buyers etc., little attention is paid to the Chinese subsidiary.

In the following, we outline the risks for management and shareholders of insolvent Chinese subsidiaries, in case no proper liquidation is initiated and conducted according to the Chinese law.

Scenario I: Closing the company without Legal Procedure

1. Civil liability
The shareholders and actual controllers of the Chinese company can be held jointly liable for the debts of the company. This follows from Art. 3 of the Prosecution Guidelines and Arts. 18, 19 of the Company Law Application Provisions , whereby the shareholders of a limited liability company and its “actual controller” (natural persons or enterprises) shall be jointly liable for the debts of the company, given they did not liquidate the company in a proper way.

There is no express definition of the “actual controller”. In practice, the legal representative, the General Manager or the persons who have material influence on the Chinese company are regarded as “actual controller”. This can also include the insolvency administrator of the foreign parent company.

The creditors have the option to take legal action against the shareholder and actual controller of the company before the People’s Court. Enforcement of the decision can be subject to International Judicial Assistance.

2. Criminal liability
In severe cases involving significant amounts of debts and tax payable, the shareholder and actual controller of the Chinese company may face criminal liability. Based on Art. 6 of the Prosecution Guidelines and Arts 159, 201, 203 and 204 of the Chinese Criminal Law, the relevant persons who maliciously escape debts, fees and tax in a significant amount are criminally liable.

3. Administrative Liability
The Legal Representative of the Chinese company is not allowed to assume positions in companies as Director, Supervisor or Senior Manager within 3 years after the Business License of the Chinese company has been revoked.

The Investor and Legal Representative of Chinese company can be put on a so called “black-list” of the government. This would prevent making new investments or even visiting China in the future. Although, such “black-lists” are not based on legal provisions, they do exist in practice.

The legal reference is Art. 147 of the Company Law, whereby a person in any of the following categories may not serve as a director, supervisor, or senior management personnel:
- a person who acted as a director, factory manager, manager in a company which has been declared bankrupt or liquidated and who is personally accountable for the bankruptcy or liquidation of the company, and a three year period has not lapsed since the completion of bankruptcy or liquidation of such company;
- a person who has acted as legal representative of a company which has its business license revoked or being ordered to close down for a breach of law and who is personally accountable, and a three year period has not lapsed since the revocation of the business license of such company.

Scenario II: Bankruptcy Procedures

1. Rejection of Bankruptcy Procedures by the Court:
After an application for opening bankruptcy procedures has been made by the Chinese company, the decision to actually open bankruptcy procedures is in the full discretion of the People’s Court. Furthermore, the definition of insolvency in the bankruptcy court is unclear and lacks authoritative interpretation as well as consistent application in the legal practice.

According Art.2 of the Bankruptcy Law , one main condition for bankruptcy is “insolvency” of the company in question. If the court applies the balance sheet insolvency test and the Chinese subsidiary has accounts receivable against its foreign mother company which are nearly equal all its due debts, it would not be insolvent from the point of view of this test.

Since the Bankruptcy Law has been published only for two years, the courts lack experience in handling such cases. In practice, courts tent to be unwilling to accept bankruptcy applications due to the complexity and time-consumption of these procedures.

2. Acceptance of Bankruptcy Procedures by the Court
If the application is accepted, the company will be taken over by an insolvency committee appointed by the court. The mother company will lose control over the company.

The insolvency committee will check whether the registered capital has been paid by the investor and whether this registered capital has been withdrawn by the investor. To some extent the account receivable against the parent company could be regarded as a kind of undue withdrawal of capital by the shareholder (parent company) causing the insolvency of the company. In this case the shareholder can be held responsible for such action (see Alternative I). The Chinese insolvency committee can act as representative of the Chinese subsidiary and participate as such in the insolvency procedure of the foreign parent company.

The administrative liabilities and consequences for the Legal Representative as set out in Scenario I also apply in this scenario.

Alternative III: Liquidation Procedure

Based on Art. 188 of the Company Law, the pre-condition for a liquidation conducted by the company itself is that the company has enough assets to pay all debts.

According to Art. 1 of the Guiding Opinions and Art. 74 of the WFOE Rules , the company shall establish a liquidation committee which shall include a representative of the company, representatives of the creditors and the authorities concerned, a Chinese lawyer and a Certified Public Accountant. However, in practice, some of the local authorities apply a flexible policy for the constitution of the liquidation committee, e.g. the accountant must not necessarily be a certified public accountant.

Once the liquidation is legally finished, no liabilities as set out in Alternative I and II occur to the shareholders and actual controllers of the Chinese Company.

However, the administrative liabilities and consequences for the Legal Representative as set out in Scenario I also apply in this scenario.

Conclusion:
While dealing with the insolvency of the mother company in the US or Europe, the fate of the Chinese subsidiary must be taken seriously. Non-compliance with the above outlined legal regime can destroy future business activities in China. Especially the personal consequences for the management personnel should be considered.

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