Chinese bankruptcy practice and governmental measures

Grandall Legal Group
Shen Tianfeng
[email protected]

On June 1 2007, the new Enterprise Bankruptcy Law of the PRC (EBL) came into force. It applies to all legal entities, including foreign investment enterprises, except for partnerships and sole proprietorships. The adoption of EBL announced the start of a new bankruptcy regime in China by unifying all the prevailing laws, rules and regulations into a single, coherent code. It saved many failing businesses during the 2008 global financial turmoil and economic slowdown.

Limited liability of enterprise

Two key issues confronted by most failing enterprises are: i) how to maintain normal business operations; and ii) how to ensure each creditor is compensated fairly. If the enterprise ceases operation, it will not only reduce creditors' confidence but also result in unemployment, social instability and diminishing enterprise value. Further, each shareholder is only liable to the enterprise to the extent of its contributed capital, while the enterprise is only liable to its debt to the extent of its assets. Thus, when an enterprise is insolvent the final losses will be borne by creditors, who may take legal proceedings to seize up or freeze the enterprise's assets to protect their own interests. This inevitably leads to ceasing the enterprise operation.

Bankruptcy advantages

- According to Ss 19, 20 and 21 of the EBL, once bankruptcy is initiated, any civil action or arbitration involving the debtor shall be suspended. Thus, the enterprise is under special protection where normal operations are maintained;

- All creditors will be treated fairly as the debtor is under creditor-led operations and management; and

- In principle, that part of the debt that cannot be paid off by assets is not required to be repaid after bankruptcy procedure begins. This helps the enterprise move forward.

Bankruptcy techniques

The entire bankruptcy is a bargaining process among creditors that include shareholders, management and others. The difficult question is how to compensate the creditors fairly.

The wisdom of the law is to realise justice through fair procedures. During bankruptcy, an independent third party (administrator) will be appointed to manage the enterprise. The administrator shall work out the normal creditors' payoff ratio upon examination of the declared debts and evaluation of the enterprise assets. It will also examine different reorganisation, restructuring and compromise proposals. If none of these are agreed by the creditors, the enterprise will be liquidated. The creditors therefore encourage enterprise reorganisation in order maximise the enterprise value.

Failing enterprise characteristics

Some characteristics occur to failing enterprises during periods of financial difficulty.

i. Early stage

The debt ratio is increasing, banks become cautious when providing finance and the enterprise's cash flow is diminished or negative. Some enterprises even start to borrow high-interest loans. The government can:

a) remind and recommend the enterprise to reduce investment risks, cut down foreign investment and fix asset investment;

b) assist the enterprise in finalising procedures for transferring the equity of foreign investments and transferring fixed assets;

c) extract parts of non-utilised land to the most permissible extent;

d) defer those enterprise projects that cannot be immediately started; and

e) assist the enterprise in registering the asset-backed loan.

ii. Middle stage

The enterprise fails to pay the loan on the due date, with the exact repayment date not determined. The government can:

a) assist the enterprise in making a debt payment plan based on its real financial status;

b) urge business and asset reorganisation, and modification of the asset and debt structure;

c) preserve relations between the enterprise and the bank by helping them to reach a debt repayment proposal and maintain the enterprise's credibility; and

d) assist the enterprise in searching for good intermediary institutes, such as accounting firms, law firms and evaluation institutes.

iii. Late-middle stage

The enterprise is insolvent with overdue debt. Banks without guaranteed assets start to seize up the assets while bank accounts are frozen. The government can:

a) assist the enterprise in organising assets and debt, and recognise the possibility of collapse and its impact on the enterprise and society;

b) preserve the bank and main creditor's interests, and prevent a domino reaction; and

c) encourage the enterprise to reach a settlement compromise with the main creditors.

iv. Late stage

The enterprise ceases operation and key management personnel are missing. The creditors of private funds and employees may seize up raw materials and inventories. The government can:

a) support initiation of the bankruptcy procedure to maintain normal business operations;

b) maintain social stability by preventing any group incidents;

c) assist the enterprise in carrying out redundancies; and

d) encourage the enterprise to reorganise, introduce new investors, provide preferential policy if needed and assist in finalising relevant