The New Draft Bankruptcy Law: Will it Advance the Non-performing Loan Industry?

The Bankruptcy Law and Types of Enterprises

The unified bankruptcy law is intended to replace the current patchwork legislation under which different legal regimes apply to individual bankruptcy or reorganization cases based upon the nature and, to some extent, the location of the debtor. At present the basic division is between state-owned enterprises (SOEs) and enterprises that are not state-owned, including collective, private and foreign-invested enterprises. Additional rules exist to deal with the insolvency of particular types of enterprises such as corporations, foreign-invested enterprises and financial institutions. Various local authorities have also supplemented applicable national laws and regulations with local rules covering all bankruptcies within their jurisdiction.

Given the current lack of a unified bankruptcy scheme, one of the major issues that confront foreign purchasers of NPLs is the problem of forcing the liquidation of a debtor, especially if it is an SOE. Moreover, and in addition to the general political problems associated with trying to force the liquidation of an often sizable local employer, if the SOE is located in one of 111 Chinese cities (which include virtually all of China's major industrial centres), it will be subject to a regime referred to as the "Capital Structure Optimization Programme" or CSOP. The CSOP regime adds a further layer of complications that directly impacts upon the interests of the purchaser of distressed debt portfolios.

The CSOP Regime and SOEs

Under the CSOP regime, decisions concerning SOE bankruptcy and reorganization are subject to a central planning process, supervised by the National Development and Reform Commission (formerly the State Planning Commission). A significant feature of the CSOP regime, especially from the point of view of secured creditors, is the priority in bankruptcy proceedings (in many cases, superior to mortgagees) given to "employee resettlement payments", which are made either to individual workers to compensate for the loss of employment in the state sector, or used in a collective scheme to keep the workers employed. In other words, even if the purchaser of a NPL portfolio is in the relatively strong - and relatively unusual - position of having properly registered mortgages over valuable collateral, it may still find itself behind the redundant employees when the mortgaged collateral is sold or auctioned.

It is not clear how these issues will be resolved under the draft unified bankruptcy law. On the positive side, the draft indicates that it will apply to enterprise legal persons, which most SOEs by now are. However, Article 162 of the current draft provides a carve out for SOES by providing that, for an unspecified period of time and subject to an undefined scope, the bankruptcies of SOEs shall be handled in accordance with the regulations of the State Council. It is unclear what this is intended to mean, but it leaves the door open for the CSOP regime to be continued into the future (CSOP was established under a number of State Council regulations, including the Notice on Issues Concerning the Trial Implementation in Several Cities of SOE Bankruptcies, issued by the State Council on October 24 1994; the Issues Concerning the Trial Implementation of SOE Mergers and Bankruptcy Circular, issued on July 25 1996 by the State Economic and Trade Commission and the People's Bank of China with authorisation from the State Council; and the Supplementary Notice on Issues Concerning the Trial Implementation in Several Cities of SOE Bankruptcies and Mergers and the Resettlement of Staff and Workers, issued by the State Council on March 2 1997.)

The Future of the NPL Market

It would be a significant setback for the NPL industry if the CSOP regime continues in place even after the passage of the unified bankruptcy law, as it effectively would mean that the bankruptcy of SOEs in the CSOP cities would remain largely a political matter rather than an economic one. It is hoped that this issue will be clarified, especially the scope of applicability of Article 162 of the draft unified bankruptcy law, before the new unified bankruptcy law is promulgated. Progress on this issue will have significant positive impact on the development of the NPL market in China, and consequently on the improvement of the entire PRC banking system.