China: New Law Ushers In Sweeping Changes To Bankruptcy Regime In China

Last Updated: 21 September 2006

The new Enterprise Bankruptcy Law of the People’s Republic of China ("PRC") (the "Bankruptcy Law") was adopted on August 27, 2006 and will take effect on June 1, 2007, superseding the 1986-enacted Enterprise Bankruptcy Law (Trial) (the "1986 Law"), governing the bankruptcy of State-owned Enterprises ("SOEs"). The Bankruptcy Law offers for the first time a unified regime applicable to all types of enterprises in China and also provides a more robust and detailed regime for enforcement of creditors’ claims. We discuss below some highlights of the Bankruptcy Law:

Scope Of The New Law

The 1986 Law only applies to the bankruptcy of SOEs, while the Bankruptcy Law provides a unified bankruptcy system for all "enterprises with legal person status," covering both SOEs and privately-owed companies, including foreign investment enterprises ("FIEs"). Individual or partnership bankruptcy, however, is not covered by the Bankruptcy Law.

Cross-Border Insolvency

The Bankruptcy Law for the first time incorporates specific provisions governing the administration of cross-border bankruptcies.

In relation to "outbound" insolvency cases involving the overseas assets of a PRC debtor, Article 5 states: "The validity of any bankruptcy proceedings commenced in accordance with this Law shall extend to the properties of the debtor outside of the PRC." China has not adopted the United Nations Commission on International Trade Law Model Law on Cross-Border Insolvency ("UNCITRAL Model Law"), which provides a framework for cooperation with foreign courts on cross-border insolvency proceedings. The U.S., the U.K., and other countries that have adopted the UNCITRAL Model Law will nonetheless accept "foreign representatives" from China operating under Article 5 and pursuing assets in those countries as part of China bankruptcy proceedings where they can establish that China is the "center of main interests" of the debtor. Because the UNCITRAL Model Law does not condition any benefits on reciprocity, the U.S. and other Model Law countries will confer substantial "recognition" and cooperation for China representatives, even though there is less reciprocal benefit to the U.S. or other foreign players in China. The new U.S. Chapter 15 is a powerful tool for China "foreign representatives" to arrange for the transfer of U.S. assets and creditors to the China insolvency proceedings. U.S. creditors, on the other hand, worry that their recoveries from U.S. assets of China debtors will decrease once those assets become administered and redistributed in China under China proceedings governed by the Bankruptcy Law.

Article 5 also permits "inbound" cases, where a foreign representative from another country seeks recognition of a foreign court ruling in China, provided that the following conditions are satisfied:

There are relevant treaties or reciprocal relations between such country and the PRC;

The bankruptcy proceedings outside the PRC do not violate the State sovereignty, national security and social public interest of the PRC; and

The bankruptcy proceedings outside the PRC do not harm the lawful rights and interests of the creditors in the PRC.

These conditions are quite onerous, and the court has substantial discretion to interpret the conditions and decide whether they have been satisfied before permitting the recognition of a foreign court ruling. Nonetheless, the Bankruptcy Law is a step forward moving towards the adoption of international standards in the area of cross-border insolvency. Moreover, at least in countries adopting the UNCITRAL Model Law (e.g., the U.S. Chapter 15), China now can credibly seek to resolve the assets and liabilities of Chinese entities wherever located.

Grounds For Bankruptcy Petitions

The 1986 Law allows a creditor to file a bankruptcy petition only when the debtor is unable generally to pay its debts as they fall due. Under the Bankruptcy Law, both the debtor and its creditors are allowed to file reorganization or bankruptcy petitions to the People’s Court in the following circumstances (subject to special rules for financial institutions):

  • A creditor may apply to the court for reorganization or bankruptcy of a debtor, if the debtor is unable to pay its debts as they fall due (cash-flow insolvency).
  • A debtor may apply to the court for reorganization, conciliation or bankruptcy, if it is unable to pay its debts as they fall due, or if its assets are insufficient to pay off all debts (balance-sheet insolvency), or if it is obviously insolvent.

The Bankruptcy Law has expanded the grounds for bankruptcy petitions and has also introduced corporate reorganization and conciliation as mechanisms to revive an insolvent company.

Corporate Reorganization

Under the 1986 Law, a corporate reorganization can only be petitioned for and carried out by the government authorities. The Bankruptcy Law, however, allows either the debtor or the creditor to apply to the People’s Court for reorganization of the debtor. When a creditor petitions to bankrupt a debtor, the debtor, or its investors holding more than one third of the debtor’s registered capital, may apply to the court for reorganization after the court has accepted the bankruptcy petition, but before the debtor is declared bankrupt.

The debtor or administrator must submit a draft reorganization plan to the court within six months (or nine months with court approval) of the court’s ruling for reorganization. The draft reorganization plan must be approved by a majority of the number of creditors in each voting group, representing at least two-thirds of the total amount of confirmed claims in a class and a majority of the creditors in a class present at the creditor’s meeting. All creditors who have declared a claim are allowed to vote on a draft plan, except that secured creditors may not vote on a plan to sell the business or distribute assets, unless they give up their security interests.

The creditors approving the draft reorganization plan are classified into the following groups: (i) creditors with secured claim over specific properties of the debtor, (ii) employees with claims on salaries and social insurance premium, (iii) agencies with claims on outstanding taxes, and (iv) ordinary creditors. When the draft reorganization plan is not approved by all of the voting groups, the debtor or the administrator can still apply to court for approval, if the reorganization plan satisfies certain conditions. If reorganization plan is not approved or the debtor does not implement the reorganization plan, the court may declare the debtor bankrupt.

Conciliation

A debtor may apply to the People’s Court for conciliation of its debt after the court accepts the bankruptcy application. If the court approves the conciliation application, it will make a public announcement and convene a creditors’ meeting to discuss the draft conciliation plan. Once the reconciliation is approved by the creditors’ meeting and the court, the administrator shall transfer the business and assets to the debtor. To become effective, the plan must be approved by more than half of creditors present at the meeting holding more than two-thirds of the total amount of confirmed claims (excluding secured claims). If the conciliation plan is rejected, the court will declare the debtor bankrupt.

Administrator

The 1986 Law authorizes a "liquidation committee" (consisting of government officials and debtor’s management) to take control of the assets of the debtor. To address creditors’ concerns about transparency and independence of the liquidation committee, the Bankruptcy Law has introduced the role of an administrator to manage the assets and operations of the debtor as well as other legal proceedings. The administrator, who is appointed by the People’s Court, must meet the qualifications stipulated in the Bankruptcy Law. Law firms, accounting firms and bankruptcy liquidation firms or professionals from such firms are among those eligible to serve.

Administrators are required to exercise duties of loyalty and of diligence and are liable for any losses caused to the debtor’s properties that result from a breach of those duties. Professional liability insurance is required for individual administrators.

Priorities Of Claims

After the debtor is declared bankrupt, all of its assets must be sold by auction, unless otherwise determined by the creditor’s meeting. The bankrupt assets can be sold as a whole or in part. This assumes that any reorganization or conciliation has failed.

The Bankruptcy Law stipulates a scheme for claim payment priority. Unlike the 1986 Law, the Bankruptcy Law no longer gives higher priority to unpaid employee wages and social insurance premiums. Under Article 109, secured creditors have payment priority to the extent of the value of the secured properties, while the undersecured portion is treated as a common claim. Payment of claims in a liquidation must be made according to the following order:

  1. bankruptcy expenses and joint interest debts;
  2. unpaid employees’ salaries and basic social insurance premiums;
  3. outstanding tax; and
  4. ordinary unsecured credits.

Conclusion

Until the enactment of the Bankruptcy Law, China did not have a unified bankruptcy law applicable to all enterprises. Historically bankruptcies of SOEs have often been driven by public policy concerns more than the interests of creditors out of concerns for large unemployment and social instability. Bankruptcies of other types of entities have been subject to relatively vague and general bankruptcy provisions of the Law of Civil Procedure and of Supreme Court interpretations. The Bankruptcy Law, with its detailed provisions governing a broad range of enterprise debtors, will bring sweeping changes to the administration of creditrs’ claims in the PRC. More streamlined procedures will help enhance the transparency of bankruptcy proceedings. New rules, including those providing for bankruptcy petitions, role of administrators, corporate reorganization, conciliation, role of creditors and priorities of claims, will bring China’s enterprise bankruptcies closer to international standards.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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