The assumption of debts in a merger or acquisition

After the completion of a merger or acquisition, disputes often arise among the creditors, the acquirer and the acquired party over who should assume the pre-existing debts of the acquired party.

Whether an acquirer should assume the acquired party’s existing debts depends on the form and circumstances of the merger or acquisition, according to the laws and regulations currently in force.

Merger scenarios

The PRC Company Law stipulates that when an incorporated company completes a merger by absorption or by the establishment of a new company, the claims and debts of the parties involved should be inherited by the surviving company or the newly established company.

With respect to M&A and restructuring projects involving unincorporated enterprises and state-owned enterprises, the Supreme People’s Court has issued the Several Issues Regarding the Hearing of Civil Dispute Cases Related to the Restructuring of Enterprises Provisions (the Provisions) to govern issues relating to the assumption of debt upon completion of a restructuring.

The Provisions contain clauses similar to those of the PRC Company Law regarding the assumption of debts after an enterprise carries out a merger by absorption or by the establishment of a new company.

If a controlling stake in an enterprise is acquired, that enterprise will remain responsible for its debts. However, if the acquirer improperly withdraws its funds or seeks to evade those debts, and renders the acquired enterprise insolvent, the debts of the acquired enterprise must be assumed by the acquirer.

Under the PRC Company Law, when an enterprise carries out a merger by absorption, it must make an announcement to notify its creditors. But if a former owner of a merged enterprise has covered up or ignored the debt problems of the enterprise, and a creditor takes legal action against the acquirer, the case should be handled as follows: if the creditor declared its claims during the announcement period, the acquirer should bear civil liability, but may be able to recover compensation from the former owner of the merged enterprise; if the creditor fails to declare the claims within the announcement period, the acquirer will not bear any civil liability, and the creditor will have to take legal action against the merged enterprise and its original owner.

Upon completion of a merger by absorption or by the establishment of a new business, if the merged enterprise fails to cancel its registration with the authorities for industry and commerce, and a creditor sues it, a people’s court may notify the creditor of any additional liable parties, and make a ruling that such parties assume civil liability. In practice, the liable party is generally the acquirer.

Acquisition of assets

An asset acquisition agreement is a sale and purchase contract. The purchaser should be in a position to buy, and does not assume the pre-existing debts of the seller.

However, the Provisions establish a different principle to govern the assumption of debts in respect of the sale of small state-owned businesses (including the sale of corporate assets). The debts existing prior to the acquisition of assets or restructuring will be assumed by the buyer or the newly incorporated enterprise legal person.

• If a buyer incorporates the assets of an acquired enterprise into itself or converts the acquired enterprise into a branch of itself, the debts of the acquired enterprise will be assumed by the buyer (article 24).
• If a buyer uses the assets of an acquired enterprise to form a new company with another party, and the acquired enterprise legal person is cancelled, the buyer should bear civil liability for the debts existing prior to the sale of the acquired enterprise with all of its property, including the equity in the newly formed company (article 25).
• After an enterprise is sold, if the buyer has the acquired enterprise re-registered as a new enterprise legal person, and the original enterprise legal person is cancelled, the newly registered enterprise legal person should bear the debts existing prior to the sale of the acquired enterprise (article 26).

Under article 7 of the Provisions, if an enterprise uses its assets to form a new company with another party and leaves the debts in the original enterprise, and a creditor institutes legal proceedings and claims its rights against the new company and the original enterprise as a co-defendant, the new company should be held jointly and severally liable with the original enterprise to the extent of the property received.

Acquisitions by foreign investors

If a foreign investor acquires an equity interest in a Chinese
enterprise, the foreign investment enterprise formed after completion of the acquisition should inherit the claims and debts of the acquired Chinese domestic enterprise, according to the Merger and Acquisition of Domestic Enterprises by Foreign Investors Provisions (Foreign M&A Provisions).

If a foreign investor acquires the assets of a Chinese enterprise, the enterprise that sells the assets should remain responsible for its pre-existing claims and debts, according to article 13 of the Foreign M&A Provisions.

The conflict between the different principles governing the assumption of debts established by the Foreign M&A Provisions and the Provisions may dissuade foreign investors from participating the restructuring of Chinese enterprises.

In connection with this, the Ministry of Commerce sent a letter to the Supreme People’s Court asking for confirmation.

The Supreme People’s Court replied that foreign investment would not be affected by the Provisions, but should be subject to the principles governing the assumption of debts established by the Foreign M&A Provisions.

Li Jian is a partner at Concord & Partners in Beijing