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The Middle Kingdoms Chapter 11 Chinas New Bankruptcy Law Comes into Sight

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With a population containing a quarter of the world's total population and an economy that many experts believe has the potential to grow into the world's second-largest economy in the next 20 years, China certainly has attracted attention from all over the world. With this rapid economic growth comes a rapid increase of the number of business failures.2 China's current bankruptcy law of 1986, however, has been widely criticized for lagging far behind China's economy. Among the main deficiencies of the current law are its limited scope of applicability (only applicable to state-owned enterprises (SOEs)), lack of any mechanism for corporate rescue (liquidation is the primary bankruptcy mechanism) and inconsistent enforcement (primarily due to ambiguities of the law itself and the local protectionism of the courts).3 The development of the Chinese economy has long called for an effective bankruptcy law that protects the interests of creditors in a consistent manner, rules out administrative intervention and creates an effective market for restructuring and corporate control.

China began its efforts to create a modern bankruptcy law in 1994. The level of urgency of this task was elevated significantly by two events that occurred during the past decade: (1) the escalation of the size of China's non-performing loans (NPLs)4 and the increasing recognition, especially in light of the 1997-98 Asian financial crisis, of the devastating impact NPLs could have on the banking system and the national economy, and (2) China's accession to WTO in late 2001, whereby it committed itself to play by international business rules, revamp its various outdated laws and give up special protection granted to domestic enterprises and SOEs in various industries. However, due to the complexity of the issues involved5 and the lack of understanding of the bankruptcy models outside of China and how they could be applied in China, the drafters were unable to reach an agreement on the basic direction of the new bankruptcy law and put the draft law on the agenda of China's National People's Congress (NPC) until recently.

On June 21, 2004, in a move that marks a milestone in China's protracted efforts at creating an effective bankruptcy law, the NPC Standing Committee began its first round of deliberation of the long-awaited draft bankruptcy law (the "New Draft").6 Under the Legislation Law of 2000, which governs the legislative process at both national and local levels, a bill generally goes through three rounds of deliberation in the current session of the Standing Committee before it will be voted upon. As of this writing, the New Draft has gone through the second round of deliberation. Some experts predict that the new bankruptcy law may be passed by the end of 2004 and come into effect as early as January 2005. Once passed, the new bankruptcy law will address the main deficiencies of the current law, provide for a chapter 11-like reorganization for all types of business entities operating in China and help create a potentially lucrative restructuring market for international distressed investors and restructuring professionals.7

China's Current Bankruptcy Regime and the Efforts to Create a Unified Bankruptcy Law

China's current bankruptcy law is a complex, multi-layered and inconsistent system widely regarded as outdated. At the top of this system are several pieces of national bankruptcy legislation, consisting of the Enterprise Bankruptcy Law of 1986, which is only applicable to SOEs,8 and some provisions set forth in the Civil Procedure Law and the Company Law,9 which apply to both SOEs and non-SOEs.10 The national legislation is further complemented by four additional layers of laws and regulations, including (1) judicial interpretations of the Supreme Court,11 (2) regulations governing the liquidation of foreign invested enterprises (FIEs),12 (3) various administrative regulations issued by the State Council, the chief executive body in China and the rough equivalent to the cabinet in the United States,13 and (4) local regulations issued by provinces and municipalities (collectively, the "current law").14 To further complicate things, the enforcement of this complex regime is inconsistent across the country due to ambiguities of the law and lack of any clear guidelines as to its enforcement.

Features of the New Draft

The New Draft represents a radical departure from the current bankruptcy law in many important aspects. First of all, it is much more extensive than the Enterprise Bankruptcy Law. In contrast to the Enterprise Bankruptcy Law, which has only six chapters consisting of 43 sections, the New Draft has 11 chapters consisting of 163 sections.15 Furthermore, with regard to the scope of application, the New Draft is designed to apply to all types of business entities, including SOEs, non-SOEs, FIEs, partnerships, partners of a partnership,16 sole proprietorships and sole proprietors,17 with a limited exception to certain SOEs.18 More importantly, in contrast to the current law, under which liquidation is the primary bankruptcy mechanism, the New Draft shifts the focus to corporate reorganization and introduces relevant concepts primarily borrowed from the U.S. chapter 11.19

In the New Draft, the drafters contemplate a chapter 11-like reorganization and put in place a set of brand-new provisions to implement the reorganization model.

Causes for Bankruptcy Filing

The current law defines bankrupt enterprises as those that have sustained serious losses due to mismanagement and are unable to pay off debts when they are due.20 The term "mismanagement" has proven vague and difficult to apply in practice. Under the New Draft, bankrupt entities are more clearly defined as those that either (1) do not have sufficient assets to pay off all liabilities or (2) are unable to pay off debts when due. These two tests correspond to the balance-sheet insolvency and equitable insolvency tests in the United States, respectively.21 With respect to the equitable insolvency test, inability to pay debts when due is presumed if the debtor ceases to pay its debt when due and there has been a "continued failure" on its part to pay its debts. The term "continued failure," however, is ambiguous and, in the absence of any further clarification, may become a major source of litigation.

Appointment of an Administrator

Under the current law, the liquidation and disposition of the assets of the debtor is entrusted to a court-appointed liquidation team, many members of which are typically designated by the local government where the debtor is located.22 This provision has been widely criticized by bankruptcy scholars as a source for local protectionism. In contrast, the New Draft provides that the court shall appoint a duly qualified administrator to manage all of the assets of the debtor.23 Intermediaries such as lawyers and accountants may serve as bankruptcy administrators, and government agencies will no longer play an active role in the administration of the bankruptcy estate. The administrator may also engage members of the incumbent management to manage the business of the debtor.24

Reorganization Period

The New Draft provides for a "reorganization period" of up to six months from the date of the court order approving the commencement of the reorganization. Such a period may be extended for another three months for cause by motion of the debtor. The administrator must submit its reorganization plan during the protection period, or the reorganization process will terminate and the debtor will be liquidated.25 The reorganization period roughly mirrors the exclusivity period under the U.S. Bankruptcy Code, under which the debtor generally has 180 days (i.e., the 120-day-exclusivity period plus an extension of 60 days granted by courts for cause) during which to propose a reorganization plan.26 Notably missing in the Draft Law, however, is the right of creditors to propose competing plans following the expiration of the reorganization period.

Power of Administrator to Set Aside Certain Transactions

The New Draft provides for the power of the administrator to set aside certain types of transactions that occur within the statutory periods prior to the bankruptcy petition. The length of the statutory periods varies depending on the nature of the transaction. For example, the statutory period for the repayment of debt by the debtor with knowledge of its insolvency is six months, and such period may be extended by the court upon the request of the administrator. Transactions may be set aside if they occur within one year prior to the bankruptcy petition and involve (1) transfer of assets without consideration or without reasonable consideration, (2) improvement of creditors' position by providing collateral to previously unsecured creditors or providing additional collateral to secured creditors, and (3) repayment of debts that are not yet due.27

Financial Institutions Bankruptcy

The New Draft generally applies to financial institutions as well, except that certain issues concerning the bankruptcy of commercial banks will be governed by separate regulations to be made by the State Council.28 Such regulations will include the requirement of the approval of relevant banking regulators for the bankruptcy filing by commercial banks.29 This is primarily due to concerns over protecting customer assets placed in trust with commercial banks and the potential social unrest that may be caused by the large number of depositors involved in the bankruptcy of a commercial bank, issues with which China has had little experience dealing in the past.30

New Law Will Help China Grow

The submission of the New Draft to the Standing Committee of the NPC is a major breakthrough in China's 10-year long march toward creating a unified bankruptcy law. Some experts are hopeful that the New Draft will be passed by the end of 2004 and come into effect in 2005. Once passed, the new bankruptcy law will contribute to the stability and long-term growth of China's economy. China may become their next big playground in the not-too-distant future for distressed debt investors and restructuring professionals.31


Footnotes

1 James H.M. Sprayregen P.C. and Jonathan P. Friedland are attorneys in the Restructuring, Insolvency, Workout and Bankruptcy Group, and Yong Wang is an attorney in the Corporate Group, of Kirkland & Ellis LLP. All three are members of the firm's China Practice Group; Mr. Wang is a native of the People's Republic of China and holds a J.D. from Columbia Law School in the United States and an LL.B. from Peking University Law School in China. He works closely with the firm's Restructuring, Insolvency, Workout and Bankruptcy Group in its East Asian dealings. Return to article

2 According to the Supreme Court Work Report submitted to the National People's Congress in the respective years, the number of bankruptcy cases filed with and accepted by Chinese courts has increased to approximately 6,000 every year since 1996, up from 710 in 1993. The types of debtors have also expanded dramatically. In 1997, 3,735 of the 5,396 bankruptcy cases were filed by non-SOEs, including so-called collectively owned enterprises, privately owned companies and sino-foreign joint ventures. Return to article

3 Pursuant to §5 of the Enterprise Bankruptcy Law, the local court where the debtor is located has the jurisdiction over the bankruptcy of the debtor. Since local governments exert a large influence on the staffing and funding of local courts, the Chinese court system is widely regarded as not independent and as a main source of local protectionism. Return to article

4" Estimates of China's NPLs range from approximately 18-40 percent of total loans outstanding at the end of 2003 compared to typical NPL ratios of 2-3 percent in developed countries. The vast majority of the NPLs are owed by SOEs to China's four state-owned commercial banks, i.e., Bank of China, Industrial and Commercial Bank of China, Agricultural Bank of China and China Construction Bank. Return to article

5 China's official efforts to create a unified bankruptcy system started in 1994 with the establishment of a drafting committee at the direction of the Financial and Economic Committee of the NPC. The decade spent on drafting the New Draft indicates how fiercely divided legislators have been over the treatment of interests of different parties involved in bankruptcies. Among the most controversial issues are the bankruptcy of SOEs, the rehabilitation of laid-off employees and the bankruptcy of financial institutions and public companies. Return to article

6 The current draft is entitled The Enterprise Bankruptcy and Reorganization Law. Return to article

7 §27, Legislation Law. Return to article

8 The Enterprise Bankruptcy Law is at the center of the current bankruptcy regime. It was passed by the National People's Congress on Dec. 2, 1986, and came into effect in Nov. 1, 1988. The law is very short, consisting of only six chapters and 43 sections. Return to article

9 The Company Law of 1994, amended as of Dec. 25, 1999, is the main corporation law in China. Return to article

10 See Chapter 19 (§§199-206), Procedures for the Bankruptcy of and Debt Repayment by Enterprise Legal Persons, The Civil Procedure Law, amended as of April 9, 1991. See, also, §§57 and 158 and Chapter 8 (§§189-198), The Company Law. Return to article

11 The most important of such judicial opinions of the Supreme Court include Opinions on Several Issues Relating to the Application of the Civil Procedure Law, issued on July 14, 1992, and Rules on Several Issues Relating to the Hearing of Enterprise Bankruptcy Cases, issued on Sept. 1, 2002. Return to article

12 See The Foreign Invested Enterprises Liquidation Measures, promulgated by the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) (now part of the Department of Commerce), effective as of July 9, 1996. An FIE is a Chinese company with one or more foreign shareholders. The foreign shareholders are generally required to hold an aggregate of at least 25 percent of the equity of the company. Return to article

13 See State Council Notice on Relevant Issues Relating to the Trial Implementation of Bankruptcy of SOEs in Several Cities (guofa [1994] No. 59), issued on Oct. 25, 1994, and State Council Supplemental Notice on Relevant Issues Relating to the Trial Implementation of Bankruptcy, Merger and Acquisition of SOEs in Selected Cities and Employment of Unemployed Workers (guofa [1997] No. 10). The two State Council notices served as the main catalyst for the bankruptcy experiments, which started in 18 selected cities in 1994 and spread across almost all other cities in China. See Shuguang, Li, A Deliberation on The Key Issues of the New Draft Bankruptcy Law of Mainland China. Return to article

14 Guangdong Province has been a pioneer in local bankruptcy legislation. In August 1993, Guangdong promulgated the Guangdong Province Company Bankruptcy Regulations. Several months thereafter, local bankruptcy rules were made at the municipal level in Shenzhen of Guangdong Province, which is one of China's four special economic zone at that time. See Shenzhen Special Economic Zone Enterprise Bankruptcy Rules, effective as of March 1, 1994. Return to article

15 The 11 chapters consist of General Rules, Bankruptcy Filing and Acceptance, Bankruptcy Administrator, Bankruptcy Estate, Registration of Claims, Creditors' Meeting, Reorganization, Mediation, Liquidation, Legal Liabilities and Supplemental Rules. Return to article

16 The Partnership Enterprise Law, effective as of Aug. 1, 1997, provides for a new business form of "partnership enterprise," which is similar to the general partnership in the United States. All partners of such a partnership enterprise are personally, jointly and severally liable for the debts of the entity. Limited partnerships do not exist in China at this time. §2, Partnership Enterprise Law. Return to article

17 Under the Sole Proprietorship Law, effective as of Jan. 21, 2000, sole proprietors are personally liable for the debts of the entity. See §2, Sole Proprietorship Law. Return to article

18 This exception covers approximately 2,000 SOEs designated by the State Council, most of which are military and mining enterprises. The bankruptcy of these SOEs will proceed pursuant to the existing administrative closure measures for SOEs, which require that all bankrupt estates, including those that secure creditors' claims, be applied to rehabilitate the employees first rather than pay off creditors. The bankruptcy of these SOEs is expected to be completed in the next three to five years. Return to article

19 However, only entities with a legal person status can be reorganized, which means partnerships and sole proprietorships cannot be reorganized. Return to article

20 §3, Enterprise Bankruptcy Law. Return to article

21 Equitable insolvency is defined as the condition that exists when a debtor's liabilities, fairly discounted, exceed its assets. It should be noted that even finance and bankruptcy experts in China generally are not sophisticated enough to properly use the concept of present value, which is critical to the calculation of assets and liabilities under the equitable insolvency test. It would be interesting to see how legislature will clarify this test and how it will be applied in practice after the new law is enacted. Return to article

22 §24, Enterprise Bankruptcy Law. Return to article

23 In contrast to the New Draft's administrator model, under the U.S. Bankruptcy Code, the debtor-in-possession (DIP) continues to operate the debtor's business by default unless it needs to be removed and replaced by a trustee for cause. It has been debated among the drafters whether the new bankruptcy law should introduce the same DIP default rule. However, due to significant concerns about entrusting the bankrupt business to the same group of people who often have contributed to, or even caused, the bankruptcy of the business in the first place, the drafters decided not to take that path. But the drafters did include a provision in the New Draft that allows the incumbent management to continue to operate the debtor's business under the supervision of the administrator. Return to article

24 Chapter 3, New Draft. Xinxin, Wang, "The New Bankruptcy Law About to Be Unveiled," www.ccelaws.com/artclDtl.asp?566||all, CCELAWS (Feb. 17, 2004). Return to article

25 Li, supra. Return to article

26 11 U.S.C. §§1121(b) and 1121(d). Return to article

27 Wang, supra. Return to article

28 "The Breakthrough of Bankruptcy Law," Caijing Magazine (June 2004). Return to article

29 The chief regulator of the banking industry is the China Banking Regulatory Commission, or CBRC, which was divested from the People's Bank, China's central bank, in March 2003. Return to article

30 "Bankruptcy of Financial Institutions Caused Concerns about Stability of Society," SENEWS, www.sznews.com/n1/ca1001791.htm (June 22, 2004). Return to article

31 Some experts predict that an active restructuring market is likely to emerge several years after the enactment of the new bankruptcy law. In order to establish an effective bankruptcy system, however, several other related laws, most notably the Company Law and the Securities Law, both of 1999, will need to be revised. Return to article

Journal Date: 
Wednesday, December 1, 2004
Bankruptcy Rule: 

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