Bankruptcy & Insovency

Bankruptcy reform: Bad news for debtors

But good news for creditors according to Lei Wu and Ding Fa Liu of Jun He Law Offices

China has taken great efforts to reform its bankruptcy regime for a transition to a modern, market-based economy. After 12 years' drafting and reviewing, the Standing Committee of the National People's Congress (NPC), China's national legislature, finally adopted the Enterprise Bankruptcy Law of the People's Republic of China on August 27 2006. The New Bankruptcy Law came into effect on June 1 2007, replacing the Enterprise Bankruptcy Law of the People's Republic of China (For Trial Implementation), which was promulgated on December 2 1986 and came into force on November 1 1988.

Subsequently, in an effort to facilitate the enforcement of the New Bankruptcy Law, the People's Supreme Court issued three judicial interpretations in April 2007, all of which took effect on June 1 2007.

On October 28 2007, the Standing Committee of NPC amended the Civil Procedure Law of the People's Republic of China. The amendments, to be effective on April 1 2008, include deletion of Chapter 19 (Bankruptcy and Debt Repayment Proceedings for Legal Person Enterprises) and further standardising of bankruptcy legislation.

Before the promulgation of the New Bankruptcy Law, the Chinese bankruptcy legal system was mainly composed of the Old Bankruptcy Law, Chapter 19 of the Civil Procedure Law, two circulars of the State Council regarding bankruptcy of state-owned enterprises (SOEs), and certain judicial interpretations and local regulations. The enactment of the New Bankruptcy Law is a milestone in the evolution of the Chinese bankruptcy legal system.

Applicability

The New Bankruptcy Law applies to all entities that hold legal person status, whether SOEs, private companies or foreign-invested companies, listed companies or non-listed companies, financial institutions or non-financial institutions. The Old Bankruptcy Law applied to SOEs only, while Chapter 19 of the Civil Procedure Law applied to legal person enterprises that were not SOEs. With the New Bankruptcy Law, all companies in China will be able to follow a single, unified bankruptcy system. The New Bankruptcy Law does not apply to natural persons, sole proprietorships, partnerships and other non-legal-person entities. The Chinese legislature believes that it is still not advisable to enact laws regarding the bankruptcy of such parties.

Administrators

The New Bankruptcy Law has introduced the new concept of administrators, widely used in the bankruptcy system of most other jurisdictions. Consistent with international practice, under the New Bankruptcy Law, intermediary organisations such as law firms and accounting firms are invited by the courts to act as administrators. The administrator system will ensure a fairer, more efficient bankruptcy proceeding, in which there is less government interference. Under the old bankruptcy regime, the liquidation committee responsible for all bankruptcy matters and was composed of government officials. It was therefore inevitable that the liquidation committee would compromise the creditors' interest if a conflict with the public or government's interest arose.

The New Bankruptcy Law provides that the administrator shall be appointed by the court when it accepts the bankruptcy petition. The administrator's major authorities include taking over and preserving the assets of the debtor and assuming overall responsibility for routine bankruptcy matters. The court will decide the compensation of the administrators, which shall form part of the bankruptcy costs and shall be paid in priority out of debtor's assets.

The People's Supreme Court issued the Regulations on Appointing Administrators when Hearing Enterprise Bankruptcy Cases and the Regulations on Determining the Compensation of Administrators when Hearing Enterprise Bankruptcy Cases on April 12 2007, providing measures for appointing administrators, and a basis for calculation of their compensation. Pursuant to the Regulations on Appointing Administrators, the court shall select an administrator from the court's list. All high courts and some intermediate courts have prepared lists of administrators, recognising law firms and accounting firms that are qualified to act as such; the Jun He Law Office has been appointed by the High Courts of both Beijing and Shanghai as their administrators.

Bankruptcy proceedings

Under the New Bankruptcy Law, a creditor, debtor, or, in the case of a financial institution, the relevant authority of the State Council, may apply to the court to initiate the bankruptcy procedure. Two threshold conditions must be reached for a debtor to initiate the bankruptcy procedure. The debtor must be unable to pay debts that are due; it must not have enough assets to pay off all its debts or clearly lack the ability to do so. The requirement to satisfy both conditions is unique, as the bankruptcy laws in most other jurisdictions apply the first condition only. This was designed to control the number of enterprises subject to bankruptcy petitions, since a great number of SOEs have liquidity issues. The New Bankruptcy Law provides that a debtor must meet the insolvency test for three potential options – restructuring, settlement, and bankruptcy liquidation. Bankruptcy liquidation is apparently the last resort when restructuring or settlement fails.

The threshold conditions for creditors to file bankruptcy petition against their debtors and their options differ from those of the debtor. A creditor may petition the court to restructure or liquidate its debtor if the debtor is unable to pay debts that are due. The creditor cannot file the petition for settlement.

If a financial institution meets the insolvency tests discussed above, the financial regulatory authority under the State Council may petition the court to restructure or liquidate the institution.

In addition, when a legal enterprise has been dissolved but not been liquidated, or has not completed its liquidation, if its assets are not enough to pay off its debts, the person responsible for liquidation by operation of law shall apply to the court for a bankruptcy liquidation.

Restructuring

The New Bankruptcy Law has introduced restructuring as another alternative for enterprises that are insolvent, aiming to provide debtors with an opportunity to be rescued and revived. Under the restructuring proceeding, a debtor can be restructured pursuant to a restructuring plan approved by the court, enabling it to discharge some or all of its debts within a certain period of time while continuing its business.

Unlike the reorganisation proceeding under the Old Bankruptcy Law, which had to be initiated by the debtor's supervising authority, the restructuring proceeding under the New Bankruptcy Law may be initiated in one of the following circumstances: a debtor or creditor may directly petition the court to restructure the debtor on the ground that the debtor is unable to pay its due debts, and its assets are inadequate to discharge all its debts, or it is obviously insolvent or obviously appears to be insolvent; or where a creditor has already petitioned for the bankruptcy of a debtor, the debtor or a shareholder holding one-tenth or more of the registered capital of the debtor may file an application with the court to restructure the debtor. Also, the restructuring proceeding under the New Bankruptcy Law is not subject to the maximum two-year limit that applied to the reorganisation proceeding under the Old Bankruptcy Law.

The debtor or administrator should prepare and submit a draft restructuring plan to the court and hold the creditors' meeting within six months of the court ordering the debtor to restructure. The court may grant a three-month grace period if the debtor or administrator has legitimate grounds. Creditors will be divided into different classes to vote on the draft restructuring plan. The classes include secured liabilities and employee entitlements, such as wages, medical and disability subsidies, social insurance contribution allocated to the employees' personal accounts, and statutory compensation owed to employees. Taxes and unsecured liabilities are also included. The court has the right to establish a sub-class of small claims under the class of unsecured liabilities to vote separately if necessary. Moreover, if the draft-restructuring plan involves adjustment to the interest of the debtor's shareholders, a class of shareholders should be set up to vote on the related matter. Once adopted by the creditors' meeting, the restructuring plan shall be subject to court approval. The plan will be binding on all parties upon approval by the court. However, even if the plan fails to be adopted by the creditors' meeting, the court may approve it, if certain conditions are met. The debtor shall be responsible for the implementation of the plan under the administrator's supervision. The administrator is required to hand over all the debtor's assets under its control to the debtor.

Priorities

The New Bankruptcy Law reinforces the priority of secured creditors regarding the debtor's secured assets. This has been considered a great improvement to the Chinese bankruptcy system. In 1994, China began to implement a policy bankruptcy system specifically for SOEs pursuant to two circulars issued by the State Council. Under the policy bankruptcy system, employees would be paid first using the proceeds from the sale of assets, having priority over secured creditors.

The New Bankruptcy Law sets out the principle that secured creditors will have the priority to be paid over the debtor's employees. The legislative intent was that workers' interest should be further protected by the social security system. However, as part of the transition and as a compromise, the New Bankruptcy Law provides that employee entitlements from before August 27 2006 are to be paid from the secured assets in priority over secured creditor claims, if they cannot be satisfied out of the debtor's unsecured assets.

Preventing fraud

The Old Bankruptcy Law had been criticised for being easily abused and circumvented. The New Bankruptcy Law establishes a much more sophisticated system to prevent bankruptcy frauds, to protect the creditors' interest and maintain economic order in the market. By way of example, the New Bankruptcy Law provides the following provisions:

The administrator shall have the right to request the court to rescind the following activities relating to the debtor's assets that occurred within one year before the court accepted the bankruptcy petition:

  1. Transfer of assets without consideration.
  2. Entry of a transaction at an obviously unreasonably low price.
  3. Provision of security for unsecured debts.
  4. Paying off debts in advance before they become due.
  5. Waiving a third party's liability to pay debts owed to the debtor.

The administrator shall have the right to request the court to rescind any repayment that was made by the debtor to any individual creditors up to six months before the court accepted the bankruptcy petition if the debtor was insolvent at the time, unless the court decides that the repayment benefited the debtor's property. It will be illegal for the debtor to conceal or transfer assets to avoid debts, to fabricate debts, or to recognise unreal debts.

Creditors may apply to the court for additional distributions if, within two years of the conclusion of the bankruptcy procedure, it is discovered that additional assets of the debtor exist – for example, assets that were concealed or transferred to avoid paying debts, or assets that were transferred without consideration or at a significantly low price.

Financial institutions

The New Bankruptcy Law provides principles regarding the bankruptcy of financial institutions. According to the old law, China's financial regulatory body under the State Council could apply to the court to restructure or liquidate financial institutions including commercial banks, insurance and securities companies when they meet the insolvency tests that could trigger the commencement of a bankruptcy proceeding by a debtor. Moreover, when applying such measures as takeover or custody of the financial institutions that have incurred material operational risks, the financial regulatory body under the State Council may apply to the court to suspend any civil litigation or enforcement procedure against such financial institutions before the court accepts the bankruptcy petition. Under the New Bankruptcy Law, the State Council is designated as the authority to formulate implementing measures for the bankruptcy of financial institutions. To date, such implementing measures have not been published.

Cross-board considerations

The New Bankruptcy Law take into consideration that in a global economy, a bankruptcy case being resolved before a court may involve assets or creditors in other jurisdictions. Article 5 of the New Bankruptcy Law provides that the bankruptcy proceedings initiated under the New Bankruptcy Law shall be binding on the debtor's assets outside China. It further provides that the court may adjudicate, recognise, and enforce legally valid foreign court judgments and rulings on bankruptcy cases involving debtors' assets located within China, if the court believes that the petition for recognition and enforcement does not contravene basic principles of Chinese law, prejudice the sovereignty, security, and public and social interest of the country, or hurt the legitimate rights and interests of creditors in China according to international treaties or after review under the principle of reciprocity. These provisions lay out a basis for dealing with cross-border bankruptcy cases, although the effect of such provision remains to be seen.

From information publicly available, it appears that across the country few bankruptcy petitions have been filed with, and accepted and handled by courts pursuant to the New Bankruptcy Law. Therefore, it is still too early to assess the real effect and identify the issues of this law. However, with a number of provisions in the New Bankruptcy Law designed to protect the creditors' interests, foreign creditors should gain confidence in protecting their investment from fraud and other types of infringement of their rights.

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