China Sets Short Timetable for Bankruptcy Law Reform

The Draft Bankruptcy Law's Scope of Application

Unlike the current regime (or regimes), the draft law's bankruptcy procedures are applicable to both state-owned and privately held companies (including those with foreign investment), and also to partnerships and sole proprietorships. The intention appears to be to create a level playing field for all economic entities.

Nevertheless, the draft law does provide a carve-out (as is the case in some other jurisdictions) for financial institutions (Article 163) and certain state-owned enterprises (SOEs) (Article 162). Although there is some speculation as to the extent to which many of China's SOEs will be able to avail themselves of Article 162, our enquiries suggest that these will be confined to a limited number of SOEs, and will not be of general application. The draft law does not cover the bankruptcy of individuals, unless they operate in a partnership or as the sole proprietor of an enterprise.

Commencing Bankruptcy Proceedings under the Draft Bankruptcy Law

The draft law contemplates three different procedures: liquidation, reorganization and conciliation, and they are commenced upon “acceptance” by the court (i.e., not by mere submission by the applicant) of an applicant's petition. The acceptance by the court of the petition gives rise to a moratorium against litigation and enforcement proceedings (Articles 30 and 31).

In practice, the fact that acceptance of the petition is left to the discretion of the court may lead to significant delay in the commencement of insolvency proceedings. This is because the court may, for one reason or another (e.g., their overriding concern about unemployment and social instability following the liquidation), fail to accept or reject the petition promptly. Our experience with the current bankruptcy regime is that this is not uncommon, particularly in courts located away from the major business centres of China.

A liquidation or reorganization can be petitioned for by either the debtor or its creditors, but reorganization is limited to enterprises with the status of legal persons, i.e., companies but not partnerships. Further, only a debtor can apply for conciliation.

The draft law provides that a petition for reorganization or conciliation can be applied for at any time prior to the court's declaration of an order to liquidate the debtor. This may provide an opportunity for debtors to buy time, and we will have to wait and see whether some degree of tactical litigation will emerge.

Insolvency Test

Article 3 of the draft law sets out the general criteria for the initiation of bankruptcy proceedings. Ostensibly, it employs a two-limbed test: where the debtor is unable to pay off its debts when they fall due (i.e., cash-flow insolvency), and if the debtor's assets are insufficient to satisfy its liabilities (i.e., balance-sheet insolvency). Article 3 goes on to provide that a presumption arises as to the inability to pay debts as they fall due if the debtor stops paying its debts when they fall due and there has been a “continued failure” to discharge one's debts.

This is clearly ambiguous and the failure to set out a clear trigger for the presumption of insolvency (such as a 21 day statutory demand) is likely to lead to litigation and give debtors a further opportunity to delay.

It is also unclear whether both limbs of the insolvency test have to be satisfied, i.e., cash-flow and balance-sheet insolvency. More often than not, a creditor is in no position to obtain information on the latter, and it would seem onerous on a creditor to have to satisfy balance-sheet insolvency. In this respect, Article 10 of the draft law appears to suggest that so long as a debtor is unable to pay its debts as they fall due – without explicitly requiring proof of balance-sheet insolvency – a creditor may apply for the bankruptcy of the debtor. Further, Article 3 of the draft law also appears to suggest that reorganization is available so long as the easier criteria – “likely unable to pay its debts when they fall due” – is satisfied.

Although the less onerous requirement for reorganization can be attributed to a desire to assist viable businesses before it is too late, it would seem that there is a need for the draft law to clarify which tests are to be applied by the courts in deciding whether the threshold requirements for the different procedures are satisfied. Some guidance should also be given to the courts as to the nature of evidence they should take under consideration in deciding whether a matter is suitable for one or other of the procedures in the draft law. It may be better for such guidance to take the form of interpretive opinions of the Supreme People's Court or implementing regulations.

Administrator

Having no doubt observed the ongoing debate about the relative merits of “debtor-in-possession” bankruptcy regimes versus those that replace management with a court appointed administrator, the central government has come down firmly on the side of the latter.

The court appoints the administrator upon acceptance of the bankruptcy petition, and the appointment may subsequently be endorsed or revoked by the creditor's meeting. Essentially, the administrator replaces management in either operating (and running down) the activities of the debtor company in liquidation and realizing its assets for the benefit of its stakeholders, or in managing or supervising a debtor in reorganization. The administrator's performance falls under the purview of the court, and the supervision of the creditors' meeting and/or of the creditors' committee.

The introduction of the administrator into China's bankruptcy regime would appear to afford opportunities for professional services firms. Article 21 requires administrators to be members of legal, accounting or specialist bankruptcy firms or to otherwise possess “relevant professional expertise and practice qualifications”. Further, while the choice of administrator is subject to the overriding discretion of the court, it would appear open to the petitioner and other stakeholders to put forward preferred nominees. In any event, the intention is to appoint an independent professional to protect the debtor's assets and facilitate a conciliation, reorganization or liquidation – a most welcome development.

A word of caution is in order for insolvency practitioners: there is no return without risk, and although the draft law provides that the administrator's fees rank as “bankruptcy costs” (Article 39), i.e., they rank first, it also provides that the administrator owes duties to both creditors and the debtor, a breach of which may result in civil and criminal sanction.

Reorganization

Another innovation of the draft law is the introduction of a corporate reorganization or rehabilitation regime. Akin to procedures such as US Chapter 11 and English/Australian voluntary administration, reorganization is aimed at viable businesses that need temporary protection from creditors.

Essentially, reorganization is a court-supervised three-stage procedure. The first stage commences with the petition of a debtor, creditor(s) or shareholders of the debtor (who hold one-third or more of its registered capital) to the court. Upon the court's decision to permit reorganization (and bearing in mind the lack of clarity as to the thresholds to be satisfied), the second stage commences – the “reorganization period”.

Usually, the administrator will assume management of the debtor, however Article 70 of the draft law permits the debtor's management to apply to the court to continue management of the debtor, under the supervision of the administrator. It is unclear under what circumstances the debtor's management will be allowed to remain in office. However, it does appear that this is intended to be the exception rather than the rule.

Within six months of the commencement of the reorganization period, the administrator (or, if the debtor's management is still in office, the debtor) is to prepare a reorganization plan aimed at improving its financial status and business performance, including repayment plans and the restructuring of its debt. Upon receipt of the reorganization plan, the court convenes a meeting of the creditors to vote on the plan, i.e., Stage 3.

Similar to voting procedures in other jurisdictions, the creditors must be divided into different classes (for instance, secured creditors, unsecured creditors, employees). Approval of each class must be obtained, and approval of each class is determined by the affirmative vote of a majority of the creditors in that class present and voting, and comprising two-thirds in value of the debt held in that class. If approval is secured, a further application is made to the court for its sanction of the reorganization plan before it is implemented. If the creditors reject the plan, the debtor/administrator may nevertheless apply to the court for approval provided certain conditions are met (Article 86).

Perhaps of greatest interest to creditors is the fact that secured creditors are subject to a moratorium during the reorganization period. Although the right of the secured creditor is generally considered paramount, the reorganization procedure seeks to redress the imbalance that can be caused when secured creditors foreclose on the most valuable or productive assets of the debtor. However, a secured creditor is entitled to seek the court's permission to enforce on its security rights, provided that there is a likelihood that the security will either suffer damage or diminution in its value (Article 72).

Conciliation

Under the draft law, the debtor may petition for a court order for the commencement of a conciliation procedure, whereby the debtor has the opportunity to propose a settlement of its debts with its creditors. A settlement agreement must be accepted by a simple majority of the creditors who attend the meeting and together hold no less than two-thirds in value of the unsecured debts (Article 98). If the creditors' meeting fails to pass a settlement agreement, the court should issue a liquidation order (Article 99). However, there is no time limit in which to hold the meeting and, if it fails, there appears to be nothing preventing the court from giving the debtor multiple chances. The potential for tactical filings is obvious. It is also noteworthy that the moratorium so far as secured creditors are concerned is lifted once a stay order permitting the conciliation procedure is issued (Paragraph 2 of Article 96), thereby affording the debtor only limited protection.

Avoidance Provisions

The draft bankruptcy law sets out certain circumstances under which a transaction entered into by the company before winding up will be either voidable at the instance of the administrator or void. Such acts involve an undervalued sale of assets, granting security while insolvent, anticipatory debt repayment, waiver of creditor's rights, and unfair preferences (Articles 33 and 34). In addition, concealing or diverting the insolvent company's assets and acknowledging “untrue debts” are considered as void under the draft bankruptcy law.

In line with the practice in many other jurisdictions, these avoidance provisions of the draft law aim to prevent the insolvent company from acting beyond its ordinary course of business to diminish still further the value of its assets available to its unsecured creditors. They also seek to ensure that no unjustified preference is given to certain unsecured creditors at the expense of the others (i.e. applying the pari passu principle).

Set-off

Article 132 provides that where a creditor incurs a debt to the debtor before announcement of bankruptcy, the creditor may apply to the administrator for a set-off before the bankruptcy distribution plan is announced to the public.

To avoid abuse, Article 133 prohibits set-off where the creditor:

(a) acquired its claim after announcement of the bankruptcy;

(b) incurred a debt to the debtor in the knowledge that the entity has ceased payment or petitioned for bankruptcy, unless the debt was incurred by operation of law or more than one year before the bankruptcy petition; or

(c) acquired its claim with the knowledge described in (b) above, subject to the same exceptions.

Cross-border Insolvency

China's increased participation in the global economy finds expression in Article 8 of the draft law. First, Article 8 purports to extend the effect of Chinese bankruptcy procedures on debtor's assets located overseas. This, of course, is dependent on the cooperation of foreign courts. Secondly the draft law states, for the first time, that foreign bankruptcy proceedings could be binding within China on the China-based assets of a debtor.

However, this provision is to a large extent rendered illusory by the conditions that foreign proceedings will not be binding where:

(a) there is no reciprocity in the recognition of bankruptcy proceedings (either by way of treaty or practice);

(b) the foreign bankruptcy proceedings contravene Chinese public interest; or

(c) impair the legal interests of a Chinese creditor.

There are presently around 40 treaties for reciprocal enforcement of judgments between China and other jurisdictions. None, so far as we are aware, specifically refer to bankruptcy proceedings and few, if any, of these treaties involve China's major trading partners. Similar requirements apply to enforcement of foreign judgments in China; and similarly nebulous concepts such as “public interest” and “impairment” have been utilized to refuse recognition of the most meritorious of cases. Nevertheless, the fact that the draft law includes a section on cross-border insolvency at all is perhaps a significant development in itself.

Director's Liability

The draft law appears to incorporate the concepts of directorial liability for trading during insolvency and directors' disqualification orders found in other jurisdictions. In particular, Chapter 10 of the draft law imposes on the debtors, directors and officers:

(a) civil liability where the bankruptcy of the debtor is a result of a breach of their duties of loyalty and diligence to the debtor;

(b) the entire liabilities of the debtor if the bankruptcy results from their intentional acts or gross negligence;

(c) criminal penalty if such action constitutes a crime; and

(d) if guilty of any of the above, the individual concerned cannot assume directorial or managerial positions in a company for a period of five years from the date of the conclusion of the bankruptcy.

Such express penalties for misfeasance by directors is new to Chinese bankruptcy law, and should, if enforced, improve the standard of corporate governance in China.

Conclusion

It is doubtless encouraging that the central government, after 10 years of prevarication, is grasping the nettle of bankruptcy law reform. However, its efforts will be criticized as nothing more than window dressing if, as is so often the case under the present bankruptcy regime, it is unable to coerce provincial courts into accepting bankruptcy petitions against important and/or politically well-connected enterprises. This, we fear, will be difficult to achieve while the courts retain discretion as to whether or not to accept a petition. Further, as the high levels of foreign investment into China continue, the lack of any real recognition of foreign bankruptcy proceedings appears set to remain a key frustration for foreign lenders. Nevertheless, if properly implemented, the draft law should establish a modern bankruptcy regime based on the pari passu principle, administered by independent and experienced professionals.