Chinas Iron Rice Bowl Remolded

Chinas Iron Rice Bowl Remolded

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After more than 12 years of drafting, on Aug. 27, 2006, the People's Republic of China (PRC) passed the Law of the PRC on Enterprise Bankruptcy (New PRC Bankruptcy Law). With more than 130 Articles on a broad range of insolvency matters, this law is due to come into force on June 1, 2007. In this article, we look to outline some of the key provisions in the new law and consider the issues they raise.

"Top Ten"

Below we have listed what we consider to be the most important points in this new law, our New PRC Bankruptcy Law "Top Ten."

1. Unified insolvency regime applicable to wide range of entities. Currently in the PRC, separate insolvency regimes apply to different types of enterprises. For example, State-Owned Enterprises (SOEs) are dealt with under a different regime than non-SOEs. When the New PRC Bankruptcy Law comes into force, it will replace these separate systems with a single, unified insolvency regime.

The new law applies to any enterprise legal person, a term that includes SOEs and foreign investment vehicles (such as FIEs and WOFEs). The new law will not apply to individuals, representative offices or branch offices, and no mention is made of partnerships. Nor is it intended to apply to companies incorporated outside of the PRC, although there are cross-border provisions as discussed below.

2. Sets out grounds for insolvency. Article 2 of new PRC bankruptcy law states that any enterprise legal person must settle its debts in accordance with the new law if:

• it is unable to settle its due debts, and/or
• its assets are insufficient to settle all of its debts, or
• it is obviously insolvent.

The grounds for insolvency were not as clearly defined in previous laws. This has caused uncertainty over their applicability.

3. Cross-border issues. Previously, the PRC did not have legislation addressing cross-border insolvencies and the issues they raise. As China's economy looks to expand globally, addressing cross-border issues will prove critical. Article 5 of the New PRC Bankruptcy Law seeks to address both (1) the applicability of PRC proceedings in other jurisdictions, stating that PRC proceedings are binding on the debtor's property outside of the PRC, and (2) the applicability of foreign rulings in the PRC, stating that in certain circumstances, foreign proceedings will be recognized by the People's Court and implemented.

4. Role of the court. Under the new law, a bankruptcy application is made directly to the People's Court, and only the People's Court will have the power to accept or reject it. This breaks with the provisions of the 1986 Bankruptcy Law, which currently governs many aspects of the bankruptcy process and which requires approval from the relevant government department before bankruptcy proceedings can be initiated.

5. Independent administrator. Under existing arrangements, assets of a debtor are subject to the control of a court-appointed liquidation committee that typically consists of government officials and the former management of the debtor itself. Creditors are rarely appointed or represented, and concerns have been raised about transparency and the adequate protection of creditors' interests.

The new law introduces the role of an independent administrator (which can be a law firm, accounting firm, bankruptcy liquidation firm, relevant government official or similar) appointed by, and accountable to, the People's Court. This administrator will manage the debtor's assets during bankruptcy and report back to the court on the status of the company.

6. Creditor clout. In addition to receiving far more information through the independent administrator than they receive under the current structure, creditors will also have more direct involvement via creditors' meetings and a creditors' committee. The creditors' meeting will have several functions, including verifying claims, supervising the administrator, choosing members of the creditors' committee and deciding whether or not to adopt the restructuring plan, composition agreement, etc. (Article 61). The creditors' committee will perform several tasks, including supervising the management and disposal of the debtor's property, supervising the distribution of the bankruptcy estate and convening creditors' meetings (Article 68). In addition, the administrator will regularly report back to the committee.

7. Restructuring and composition procedures available. The new law introduces restructuring and composition of debt. Composition is an arrangement whereby a debt is restructured and/or rescheduled, giving debtors flexibility in the way in which they approach their debt servicing burdens.

8. Revocation of transactions before bankruptcy proceedings are accepted. The administrator can ask the People's Court to revoke transactions made at an undervalue, or otherwise preferentially, within one year prior to the acceptance of the bankruptcy application (Article 31).

9. Order of payment. Under the new law, the debtor's estate shall be settled in the following order:

(a) bankruptcy fees and joint interest debts (which are certain obligations incurred during the administration of the bankruptcy);
(b) unpaid wages, medical benefits, pensions for the disabled and related benefits;
(c) the social insurance premium other than that prescribed in (b) above and other unpaid taxes; and
(d) "ordinary" bankruptcy claims.

Secured claims over specific property will be repaid out of the secured property. If the value of the security is insufficient to repay the entire obligation due, the creditor can make a claim for the shortfall as an "ordinary," unsecured claim (Articles 109 and 110). Article 132 of the New PRC Bankruptcy Law gives a "super priority" to certain payments to employees (e.g., wages and medical benefits), allowing them to be paid in priority to secured creditors.

10. Set-off rights. Under the new law, a creditor may assert a claim for setoff of obligations with the administrator for obligations against the debtor prior to acceptance of the bankruptcy petition, with certain exceptions. Interestingly, the setoff right, though it applies to obligations against the debtor, shall be asserted against the administrator.

11. Clear procedures with role for regulator of financial institutions. The New PRC Bankruptcy Law provides a clear procedure for a bankruptcy, restructuring or composition. It is worth noting that if a financial institution becomes insolvent, the relevant financial regulator can make the bankruptcy application. (Yes, we do know that we actually listed 11 key issues in our "top 10," but each of these is so important that we didn't want to leave one out...).

Food for Thought

The new law is far broader in scope and detail than its predecessors. It also represents a major sea-change in China's approach and is a clear indication of China's transition to a modern-day market economy. As with most, if not all, new laws, there are still some kinks and glitches to be ironed out, and it is anticipated that at least some of these will be dealt with by the regulations for implementation of the new law that Beijing is expected to issue soon.

However, there are a few more fundamental areas that may give investors, financiers and lawyers cause for concern, including the following:

So much to do, so little time: It is crucial that the new law is applied consistently and effectively. This will require considerable political will, a great deal of practical and logistical planning and significant financial commitment. As the new law is scheduled to come into force in less than a year's time, we are looking at a very short timeframe. It may be cynical to question whether it can realistically be achieved but, especially in the early days of implementation, knowledge of the relevant province, locality and judge may remain critical to understanding and anticipating the outcome of a case.

Cross-border issues: The complicated, if rather disparate, system of rules governing cross-border insolvencies was once the concern of only a few select companies, particularly large multi-nationals. However, if the increasingly global nature of business is coupled with an economic downturn, cross-border insolvencies will become more and more significant.

It will be very interesting to see how the cross-border provisions in the New PRC Bankruptcy Law will be implemented. The law says any PRC bankruptcy proceeding shall be binding on the property of the debtor even if the property is located outside of the PRC, and PRC authorities will need to consider how they will enforce this. To look at a similar example, U.S. bankruptcy law grants an automatic stay on the disposition of all property of the debtor, regardless of the location of those assets. In practice, U.S. courts have difficulty enforcing the stay on creditors and assets beyond the reach of the U.S. court system. Accordingly, a U.S. court can usually enforce the protection only if there are other assets located in the United States that can be used as leverage. In that case, the U.S. court will force contempt of court on the creditor and restrict the creditor's use of those U.S.-based assets.

• There will also be a great deal of interest in how foreign insolvency proceedings are recognized. The recent announcement by authorities in Hong Kong and the PRC that legislation may soon be introduced to allow the mutual recognition and enforcement of court judgments in commercial matters has created interest on this point. However, the question remains whether there will be a simple recognition of the overseas proceeding and the overseas office-holders, or whether the PRC Court will actually examine the overseas process and the office-holder's role to see whether these are compatible with PRC law and practice.

This issue was seen relatively recently in Jinro Am. Inc. v. Secure Investments Inc., 266 F.3d 993 (9th Cir. 2001). Rather than merely rubberstamping and recognising an overseas proceeding, the Japanese court wanted to understand that process. It then looked to dovetail that overseas process with a Japanese process. This leaves us with the basic message that even if you have a valid overseas process, that does not mean that it will be automatically recognised in the PRC.

Restructurings and compositions: The introduction of procedures that facilitate a corporate rescue and a debt composition is commendable, but there are still some issues to be addressed. For example, details on the strength and duration of the moratorium need to be fleshed out.

"Super-priority" of workers' claims: Article 132 of the New PRC Bankruptcy Law gives a "super priority" to certain payments (such as wages and medical payments) to employees, allowing them to be paid these amounts in priority to secured creditors. In effect, this is simply recognition of what already happens in practice (for example, in the past some employees and other local creditors have obtained sealing orders that have frozen the operating assets (factory, plant, etc.), effectively keeping them beyond the reach of non-PRC creditors). This "super-priority" is now enshrined in the legislation, and investors and financiers should be aware that this could significantly reduce the value of a secured claim.

• Concerns of labor unions and SOEs: This law was drafted with a weather eye on the views of the labor unions (which undertook some aggressive lobbying during the new law's passage) and the concerns about the SOEs, notably the impact that significant layoffs would have on local economies and social stability. As the Financial Times says, "even though many SOEs are in financial difficulty, it is unlikely the new law will prompt a wave of closures across the country. Beijing's leaders have tried to engineer a delicate balance between shutting down state companies and appeasing millions of laid-off workers."1

Entities covered: The scope of the new law is wide enough to deal with state-owned commercial banks and insurance companies, but only time will tell if troubled companies in these sectors are ultimately handled under separate, specialised laws and procedures, as is the case in other jurisdictions.

Conclusion

The potential value of this new law is considerable. It will play a major part in the transition of China into a modern, market-based economy.

 

Footnotes

1 Yeh, Andrew, Financial Times, Aug. 31, 2006.

Journal Date: 
Wednesday, November 1, 2006