Second Judicial Interpretation Of The PRC Enterprise Bankruptcy Law - Insolvency/Bankruptcy

The People's Supreme Court of the PRC promulgated the second judicial interpretation on various issues in relation to the application of the PRC Enterprise Bankruptcy Law (EBL) on 16 September 2013 (2nd Interpretation) . It consists of 48 articles with a key focus to ascertain assets of the debtor company which is subject to bankruptcy proceedings (Debtor). This article highlights the key provisions in this 2nd Interpretation and the distinction between this 2nd Interpretation and the relevant Hong Kong insolvency provisions.

Overview

The 1st Interpretation of the EBL, was published on 26 September 2011 (1st Interpretation), provides detailed explanations of the insolvency tests that the PRC Court would accept when submitting a bankruptcy application. Compared to the 9 Articles of the 1st Interpretation, the 48 Articles of the 2nd Interpretation cover extensive issues relating to assets (see Table 1).

Table 1

Distinction between Debtor's assets and assets with diverse interests in ownership

According to the 2nd Interpretation, in addition to cash on hand and tangible assets, assets of the Debtor may include debts, equity, intellectual property, charged assets, interests in property (Art. 1 of 2nd Interpretation). Where assets are in possession of the Debtor arising from warehousing, custody, consignment, leasing and state-owned assets, they should not be regarded as Debtor's assets (Art. 2 of 2nd Interpretation).

For secured assets which have already been discharged or realised with surplus sale proceeds, they become free assets of the Debtor which are applicable to satisfy the bankruptcy costs and expenses (Art. 3 of 2nd Interpretation). Debtor with a joint or specific ownership interest in properties, the PRC Court declares that bankruptcy proceedings are valid grounds for the legal division of asset(s) according to the respective ownership interests (Art. 4 of 2nd Interpretation). Effectively, assets which may be available to creditors have been broadly elaborated in the 2nd Interpretation.

By contrast, the Statement of Affairs of a Hong Kong company in liquidation is the key source of information for assets that may be available for realisation (S. 190 of Hong Kong Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap.32)). Court appointed provisional liquidator or liquidator should take custody of all assets that a company is or appeared to be entitled (S. 197 of Cap. 32). The liquidator may apply to court for the vesting of property of a company which is being wound- up (S. 198 of Cap. 32). Typically, secured creditor(s) would prove their residual claim if there is a deficiency after realisation of the charged assets. Assets with disputed ownership would usually be determined by court if a commercial negotiation is not achievable.

Avoidance of attachments and preservation of assets

Articles 5 to 8 of the 2nd Interpretation ascertain that asset under the enforcement action would form part of the bankruptcy estate. Essentially, upon acceptance of a bankruptcy application by the PRC Court (the Relevant Date), any enforcement of the Debtor's property by creditor or interested party shall cease (Art. 5 of 2nd Interpretation; Art. 19 of EBL) and the underlying asset shall become available to the general body of unsecured creditors. Where bankruptcy application is dismissed or the bankruptcy proceedings are completed, original suspended enforcement action shall be resumed (Art. 108 of EBL).

Additionally, the Administrator may take out a court application to actively preserve Debtor's property from any enforcement. Creditor or interested party who has already preserved the assets of the Debtor should promptly remove such preservation measures after the Relevant Date.

These provisions are equivalent to Sections 181 and 183 of the Cap. 32 that aim to preserve assets subject to enforcement or execution at any time after the presentation of a winding-up petition but before a winding-up order has been made.

Voidable disposition of property and early repayment of debts

According to Art. 31 and 32 of the EBL, disposition of Debtor's property at unreasonable price, without consideration or triggered by the abandon of equity interests, would be subject to challenge. Administrator may invoke a court application to challenge the transferee to return the property and the Debtor to repay the sale proceeds. Failure of the Debtor to return the sale proceeds would enable the transferee to claim the estate at a priority immediately after the first ranking bankruptcy costs and expenses (Art. 10 &11 of 2nd Interpretation, Art 113 of EBL). Administrator should also note that their potential personal liability for not invoking a court application to pursue any voidable disposition of assets (Art. 9 of 2nd Interpretation).

Early repayment of premature debts by Debtor may also be regarded as disposition if repayment was made within 6 months prior to the Relevant Date, during which the Debtor was insolvent (Art. 12 of 2nd Interpretation). This Article is equivalent to the unfair preference claim in Hong Kong against creditors for receiving preferred payments or assets of Debtor in priority to other creditors. However, it is silent as to whether or not the burden of proof of intention to prefer is required and if the claw back period would extend beyond 6 months if payment was made to associates (S.266 & 266B of Cap. 32; S.50 of the Bankruptcy Ordinance (Cap.6) (BO)). It appears that the equivalent concept of associates is not set out in the 2nd Interpretation.

Interestingly, the PRC Court would support certain repayments by the Debtor. For example, settlement or composition arrangements in relation to (1) assets charged to secured creditor or (2) specific property of the Debtor, being an enforcement action of the decision of litigation or arbitration, is supported by the PRC Court. The exception is that if the underlying assets included in settlement arrangement is valued below the admitted claim or the settlement is arranged by collusion.

Article 19 of the 2nd Interpretation specifically stated that the Debtor's rights to sue its debtors shall cease at the Relevant Date. If however the Debtor has never commenced any legal actions against its debtors resulting in the expiry of the limitation period, which falls within 12 months before the Relevant Date, the PRC court shall determine the limitation period to resume from the Relevant Date.

Claims against contributories and management

The 2nd Interpretation empowers the Administrator to demand contributories to make up shortfall on unpaid capital or reverse any unauthorised distribution of capital of the Debtor. Management, founder or party with ultimate control or interest over the Debtor may also be liable for their failure to oversee such malpractice (Art. 20 of 2nd Interpretation). In addition, creditor is entitled to demand Administrator to pursue repayment from contributories to return Debtor's assets, failing which the Administrator runs the risk of replacement at court by the aggrieved creditor (Art 21 of 2nd Interpretation).

Further, directors or senior management are required to return their performance bonuses or non- regular income received from the Debtor from the exercising of their authorities or powers in their capacities. Claims arising from management on these repayments are regarded as unsecured ordinary debts (Art. 24 of 2nd Interpretation). In addition, the legal representative and management may be liable for any wrongdoings because of their intentional or grossly negligence resulting in losses of the Debtor's assets. They may also be liable for seizure of debtor's assets relying on invalid, fictitious or untrue debts (Art. 18 of 2nd Interpretation).

Liquidators in Hong Kong are empowered by law to recover unpaid calls and may claim against directors / officers who have misappropriated company's funds and breached of their fiduciary duties (S.213, 226 & 276 of Cap. 32). However, the Hong Kong court may validate application for payments out of the Debtor's estate should payments made were beneficial to the company, for example, for payment of on-going trading expenses (S.182 of Cap. 32) after presentation for winding-up and before order for liquidation.

Third party assets

The 2nd Interpretation allows the owner to claim for the return of third party assets from the Debtor. True owner should raise their claim on assets to the Administrator, and if not, to the Court. The Administrator may refuse such demand should there are outstanding counter-claims such as processing fees, custodial fees, commissions, agency and other expenses (Art 28 of 2nd Interpretation).

The 2nd Interpretation stipulates that if third party assets were sold by the Debtor, claims from the true owner shall be treated as follows (Art. 31 & 32 of 2nd Interpretation):

Assets sold before the Relevant Date - ordinary unsecured claims.
Assets sold after the Relevant Date - claim is ranked immediate after the first ranking bankruptcy costs and expenses as per Art. 113 of EBL.
Insurance compensation received in relation to third party assets - for any compensation which has not been refunded to the Debtor or it can be separated and distinguished from the general pool of the Debtor's assets, the PRC Court would support third party's claim on the compensation. Otherwise, the same treatment as above should be followed.

Table 2

Administrators should note their personal liability if third party assets are sold as a result of gross negligence. Claims arising on this basis shall have a priority immediately after the first ranking bankruptcy costs and expenses (Art 113 of EBL); and before the ordinary unsecured creditors. Administrator may be liable for any shortfall of unrecoverable sum from the Debtor's estate (Art. 33 of 2nd Interpretation).

It appears that there is no apparent provision in Hong Kong specifically to deal with the return of third party assets. Quite often, insolvency practitioner would duly examine title of assets with the assistance of solicitors, having regard to any claims of ownership or beneficial interests on the assets. Any issue of retention of title on assets should ring the bell of the insolvency practitioner requesting him/her to deal with them carefully. Otherwise, the insolvency practitioner may be liable for trespass and conversion of another's property.

Outstanding contracts in bankruptcy proceedings

Where there are contracts outstanding at the Relevant Date, the Administrator, under Article 18 of the EBL, should determine either to fulfil or terminate the contract within two months thereof. The 2nd Interpretation has explained the treatments of unfinished contracts if either the vendor or purchaser is in bankruptcy proceedings, which can be summarised in Table 2 below (Art 35 to 38 of 2nd Interpretation).

Practically speaking, provisional liquidator / liquidator in Hong Kong, immediately after their appointment, would review all outstanding contracts of a debtor company and decide whether to continue or terminate them. This would facilitate decision to trade on and minimise any potential exposure to third party claims.

Insolvency set-off

Article 40 of the EBL states that creditor can assert its rights of set- off against the Debtor on mutual debts amongst each other (Art. 41 of 2nd Interpretation). Set-off shall become effective when the Administrator receives notice of set-off issued by the creditor. Administrator who disagrees with the claim of set-off should appeal to the PRC Court within 3 months. Set-off would not be allowed if:

Debt due to the creditor from the Debtor are premature and not yet fall due at the Relevant Date;
Debt due to the Debtor from the creditor are premature and not yet fall due at the Relevant Date; and
Nature and type of debts between Debtor and creditor are different.

Further, set-off within 6 months prior to the Relevant Date may be voidable by the Administrator at the application to Court if such netting was transacted to extinguish specific debt when the Debtor was insolvent. Similarly, set-off arrangements between the Debtor's entitlement on its book debts owing by others and the unsecured portion of debt owing to a secured creditor may be voidable unless where the claim is a deficiency after realisation of the security (Art 44 & 45 of 2nd Interpretation).

Specifically, set-off is prohibited for debts due to the Debtor against any unpaid capital contributions of shareholders, in particular where the interests of the company are prejudiced because of the abuse of shareholder's rights (Art. 46 of 2nd Interpretation).

In general, insolvency set-off provisions in Hong Kong is mandatory, which takes place automatically where the mutuality of debts and credits or other mutual dealings between the same debtor and creditor are in place. Mutual dealings do not necessary relate to the same transaction (S35 of BO) insofar as the debtor and creditor are the same. Unlike the EBL, there is no specific 6 month period prior to the Relevant Date where set-off may be subject to be challenged.

Jurisdiction

Subsequent to the Relevant Date, any civil litigation subsequently filed in relation to the Debtor shall be dealt with and administered by the same PRC Court, which has accepted the Debtor's bankruptcy proceedings. In general, any previous provisions relating to corporate bankruptcy that are inconsistent with the current judicial interpretations will no longer be applicable (Art 47 & 48 of 2nd Interpretation).

Conclusion

The 2nd Interpretation provides comprehensive and practical rules for an Administrator to pursue asset preservation and recovery exercises in bankruptcy proceedings. It clearly empowers the Administrator to look for recoverable assets, raise challenges against management for unusual payments of remunerations; and deal with asset claims from third parties. Likewise, Administrator shall examine all outstanding contracts and any claims on set-off from creditors. In the event of a sizeable PRC bankruptcy case, for example with numerous pending contracts and dispute on third party assets, it would pose a real challenge to the Administrator to address all these matters with due care and diligence. Hence, the risk of exposure to personal liability of Administrator should not be underestimated.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Hong Kong: Second Judicial Interpretation Of The PRC Enterprise Bankruptcy Law