The Middle Kingdoms Chapter 11 Chinas New Bankruptcy Law Comes into Sight

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Dec/Jan 2004

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With a population
containing a quarter of the world's total population and an economy
that many experts believe has the potential to grow into the world's
second-largest economy in the next 20 years, China certainly has attracted
attention from all over the world. With this rapid economic growth comes a
rapid increase of the number of business failures.<a href="#2" name="2a">2</a> China's current
bankruptcy law of 1986, however, has been widely criticized for lagging far
behind China's economy. Among the main deficiencies of the current
law are its limited scope of applicability (only applicable to state-owned
enterprises (SOEs)), lack of any mechanism for corporate rescue
(liquidation is the primary bankruptcy mechanism) and inconsistent
enforcement (primarily due to ambiguities of the law itself and the local
protectionism of the courts).<a href="#3" name="3a">3</a> The development of the Chinese economy
has long called for an effective bankruptcy law that protects the interests
of creditors in a consistent manner, rules out administrative intervention
and creates an effective market for restructuring and corporate control.

China began its efforts to create a modern bankruptcy
law in 1994. The level of urgency of this task was elevated significantly
by two events that occurred during the past decade: (1) the escalation of
the size of China's non-performing loans (NPLs)<a href="#4" name="4a">4</a> and the increasing
recognition, especially in light of the 1997-98 Asian financial crisis, of
the devastating impact NPLs could have on the banking system and the
national economy, and (2) China's accession to WTO in late 2001,
whereby it committed itself to play by international business rules, revamp
its various outdated laws and give up special protection granted to
domestic enterprises and SOEs in various industries. However, due to the
complexity of the issues involved<a href="#5" name="5a">5</a> and the lack of understanding of
the bankruptcy models outside of China and how they could be applied in
China, the drafters were unable to reach an agreement on the basic
direction of the new bankruptcy law and put the draft law on the agenda of
China's National People's Congress (NPC) until recently.

On June 21, 2004, in a move that marks a milestone in
China's protracted efforts at creating an effective bankruptcy law,
the NPC Standing Committee began its first round of deliberation of the
long-awaited draft bankruptcy law (the "New Draft").<a href="#6" name="6a">6</a> Under the
Legislation Law of 2000, which governs the legislative process at both
national and local levels, a bill generally goes through three rounds of
deliberation in the current session of the Standing Committee before it
will be voted upon. As of this writing, the New Draft has gone through the
second round of deliberation. Some experts predict that the new bankruptcy
law may be passed by the end of 2004 and come into effect as early as
January 2005. Once passed, the new bankruptcy law will address the main
deficiencies of the current law, provide for a chapter 11-like
reorganization for all types of business entities operating in China and
help create a potentially lucrative restructuring market for international
distressed investors and restructuring professionals.<a href="#7" name="7a">7</a>

<h4>China's Current Bankruptcy Regime and the Efforts to Create a Unified Bankruptcy Law</h4>

China's current bankruptcy law is a complex,
multi-layered and inconsistent system widely regarded as outdated. At the
top of this system are several pieces of national bankruptcy legislation,
consisting of the Enterprise Bankruptcy Law of 1986, which is only
applicable to SOEs,<a href="#8" name="8a">8</a> and some provisions set forth in the Civil Procedure
Law and the Company Law,<a href="#9" name="9a">9</a> which apply to both SOEs and non-SOEs.<a href="#10" name="10a">10</a> The
national legislation is further complemented by four additional layers of
laws and regulations, including (1) judicial interpretations of the Supreme
Court,<a href="#11" name="11a">11</a> (2) regulations governing the liquidation of foreign invested
enterprises (FIEs),<a href="#12" name="12a">12</a> (3) various administrative regulations issued by the
State Council, the chief executive body in China and the rough equivalent
to the cabinet in the United States,<a href="#13" name="13a">13</a> and (4) local regulations issued by
provinces and municipalities (collectively, the "current law").<a href="#14" name="14a">14</a> To
further complicate things, the enforcement of this complex regime is
inconsistent across the country due to ambiguities of the law and lack of
any clear guidelines as to its enforcement.

<h4>Features of the New Draft</h4>

The New Draft represents a radical departure from the
current bankruptcy law in many important aspects. First of all, it is much
more extensive than the Enterprise Bankruptcy Law. In contrast to the
Enterprise Bankruptcy Law, which has only six chapters consisting of 43
sections, the New Draft has 11 chapters consisting of 163 sections.<a href="#15" name="15a">15</a> Furthermore,
with regard to the scope of application, the New Draft is designed to apply
to all types of business entities, including SOEs, non-SOEs, FIEs,
partnerships, partners of a partnership,<a href="#16" name="16a">16</a> sole proprietorships and sole
proprietors,<a href="#17" name="17a">17</a> with a limited exception to certain SOEs.<a href="#18" name="18a">18</a> More
importantly, in contrast to the current law, under which liquidation is the
primary bankruptcy mechanism, the New Draft shifts the focus to corporate
reorganization and introduces relevant concepts primarily borrowed from the
U.S. chapter 11.<a href="#19" name="19a">19</a>

In the New Draft, the drafters contemplate a chapter
11-like reorganization and put in place a set of brand-new provisions to
implement the reorganization model.

<h4>Causes for Bankruptcy Filing</h4>

The current law defines bankrupt enterprises as those
that have sustained serious losses due to mismanagement and are unable to
pay off debts when they are due.<a href="#20" name="20a">20</a> The term "mismanagement" has
proven vague and difficult to apply in practice. Under the New Draft,
bankrupt entities are more clearly defined as those that either (1) do not
have sufficient assets to pay off all liabilities or (2) are unable to pay
off debts when due. These two tests correspond to the balance-sheet
insolvency and equitable insolvency tests in the United States,
respectively.<a href="#21" name="21a">21</a> With respect to the equitable insolvency test,
inability to pay debts when due is presumed if the debtor ceases to pay its
debt when due and there has been a "continued failure" on its
part to pay its debts. The term "continued failure," however,
is ambiguous and, in the absence of any further clarification, may become a
major source of litigation.

<h4>Appointment of an Administrator</h4>

Under the current law, the liquidation and
disposition of the assets of the debtor is entrusted to a court-appointed
liquidation team, many members of which are typically designated by the
local government where the debtor is located.<a href="#22" name="22a">22</a> This provision has been
widely criticized by bankruptcy scholars as a source for local
protectionism. In contrast, the New Draft provides that the court shall
appoint a duly qualified administrator to manage all of the assets of the
debtor.<a href="#23" name="23a">23</a> Intermediaries such as lawyers and accountants may serve as
bankruptcy administrators, and government agencies will no longer play an
active role in the administration of the bankruptcy estate. The
administrator may also engage members of the incumbent management to manage
the business of the debtor.<a href="#24" name="24a">24</a>

<h4>Reorganization Period</h4>

The New Draft provides for a "reorganization
period" of up to six months from the date of the court order
approving the commencement of the reorganization. Such a period may be
extended for another three months for cause by motion of the debtor. The
administrator must submit its reorganization plan during the protection
period, or the reorganization process will terminate and the debtor will be
liquidated.<a href="#25" name="25a">25</a> The reorganization period roughly mirrors the exclusivity
period under the U.S. Bankruptcy Code, under which the debtor generally has
180 days (i.e., the 120-day-exclusivity period plus an extension of 60 days granted by
courts for cause) during which to propose a reorganization plan.<a href="#26" name="26a">26</a> Notably
missing in the Draft Law, however, is the right of creditors to propose
competing plans following the expiration of the reorganization period.

<h4>Power of Administrator to Set Aside Certain Transactions</h4>

The New Draft provides for the power of the
administrator to set aside certain types of transactions that occur within
the statutory periods prior to the bankruptcy petition. The length of the
statutory periods varies depending on the nature of the transaction. For
example, the statutory period for the repayment of debt by the debtor with
knowledge of its insolvency is six months, and such period may be extended
by the court upon the request of the administrator. Transactions may be set
aside if they occur within one year prior to the bankruptcy petition and
involve (1) transfer of assets without consideration or without reasonable
consideration, (2) improvement of creditors' position by providing
collateral to previously unsecured creditors or providing additional
collateral to secured creditors, and (3) repayment of debts that are not
yet due.<a href="#27" name="27a">27</a>

<h4>Financial Institutions Bankruptcy</h4>

The New Draft generally applies to financial
institutions as well, except that certain issues concerning the bankruptcy
of commercial banks will be governed by separate regulations to be made by
the State Council.<a href="#28" name="28a">28</a> Such regulations will include the requirement of the
approval of relevant banking regulators for the bankruptcy filing by
commercial banks.<a href="#29" name="29a">29</a> This is primarily due to concerns over protecting
customer assets placed in trust with commercial banks and the potential
social unrest that may be caused by the large number of depositors involved
in the bankruptcy of a commercial bank, issues with which China has had
little experience dealing in the past.<a href="#30" name="30a">30</a>

<h4>New Law Will Help China Grow</h4>

The submission of the New Draft to the Standing
Committee of the NPC is a major breakthrough in China's 10-year long
march toward creating a unified bankruptcy law. Some experts are hopeful
that the New Draft will be passed by the end of 2004 and come into effect
in 2005. Once passed, the new bankruptcy law will contribute to the
stability and long-term growth of China's economy. China may become
their next big playground in the not-too-distant future for distressed
debt investors and restructuring professionals.<a href="#31" name="31a">31</a>

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> James H.M.
Sprayregen P.C. and Jonathan P. Friedland are attorneys in the
Restructuring, Insolvency, Workout and Bankruptcy Group, and Yong Wang is
an attorney in the Corporate Group, of Kirkland & Ellis LLP. All three
are members of the firm's China Practice Group; Mr. Wang is a native
of the People's Republic of China and holds a J.D. from Columbia Law
School in the United States and an LL.B. from Peking University Law School
in China. He works closely with the firm's Restructuring, Insolvency,
Workout and Bankruptcy Group in its East Asian dealings. <a href="#1a">Return to article</a>

<a name="2">2</a> According
to the Supreme Court Work Report submitted to the National People's
Congress in the respective years, the number of bankruptcy cases filed with
and accepted by Chinese courts has increased to approximately 6,000 every
year since 1996, up from 710 in 1993. The types of debtors have also
expanded dramatically. In 1997, 3,735 of the 5,396 bankruptcy cases were
filed by non-SOEs, including so-called collectively owned enterprises,
privately owned companies and sino-foreign joint ventures. <a href="#2a">Return to article</a>

<a name="3">3</a> Pursuant to
§5 of the Enterprise Bankruptcy Law, the local court where the debtor
is located has the jurisdiction over the bankruptcy of the debtor. Since
local governments exert a large influence on the staffing and funding of
local courts, the Chinese court system is widely regarded as not
independent and as a main source of local protectionism. <a href="#3a">Return to article</a>

<a name="4">4</a>" Estimates
of China's NPLs range from approximately 18-40 percent of total loans
outstanding at the end of 2003 compared to typical NPL ratios of 2-3
percent in developed countries. The vast majority of the NPLs are owed by
SOEs to China's four state-owned commercial banks, i.e., Bank of China, Industrial
and Commercial Bank of China, Agricultural Bank of China and China
Construction Bank. <a href="#4a">Return to article</a>

<a name="5">5</a> China's
official efforts to create a unified bankruptcy system started in 1994 with
the establishment of a drafting committee at the direction of the Financial
and Economic Committee of the NPC. The decade spent on drafting the New
Draft indicates how fiercely divided legislators have been over the
treatment of interests of different parties involved in bankruptcies. Among
the most controversial issues are the bankruptcy of SOEs, the
rehabilitation of laid-off employees and the bankruptcy of financial
institutions and public companies. <a href="#5a">Return to article</a>

<a name="6">6</a> The current
draft is entitled The Enterprise Bankruptcy and Reorganization Law. <a href="#6a">Return to article</a>

<a name="7">7</a> §27,
Legislation Law. <a href="#7a">Return to article</a>

<a name="8">8</a> The
Enterprise Bankruptcy Law is at the center of the current bankruptcy
regime. It was passed by the National People's Congress on Dec. 2,
1986, and came into effect in Nov. 1, 1988. The law is very short,
consisting of only six chapters and 43 sections. <a href="#8a">Return to article</a>

<a name="9">9</a> The Company
Law of 1994, amended as of Dec. 25, 1999, is the main corporation law in
China. <a href="#9a">Return to article</a>

<a name="10">10</a> See Chapter 19
(§§199-206), Procedures for the Bankruptcy of and Debt Repayment
by Enterprise Legal Persons, The Civil Procedure Law, amended as of April
9, 1991. See, also, §§57 and 158 and Chapter 8 (§§189-198),
The Company Law. <a href="#10a">Return to article</a>

<a name="11">11</a> The most
important of such judicial opinions of the Supreme Court include Opinions
on Several Issues Relating to the Application of the Civil Procedure Law,
issued on July 14, 1992, and Rules on Several Issues Relating to the
Hearing of Enterprise Bankruptcy Cases, issued on Sept. 1, 2002. <a href="#11a">Return to article</a>

<a name="12">12</a> See The Foreign Invested
Enterprises Liquidation Measures, promulgated by the Ministry of Foreign
Trade and Economic Cooperation (MOFTEC) (now part of the Department of
Commerce), effective as of July 9, 1996. An FIE is a Chinese company with
one or more foreign shareholders. The foreign shareholders are generally
required to hold an aggregate of at least 25 percent of the equity of the
company. <a href="#12a">Return to article</a>

<a name="13">13</a> See State Council Notice on
Relevant Issues Relating to the Trial Implementation of Bankruptcy of SOEs
in Several Cities (guofa [1994] No. 59), issued on Oct. 25, 1994, and State
Council Supplemental Notice on Relevant Issues Relating to the Trial
Implementation of Bankruptcy, Merger and Acquisition of SOEs in Selected
Cities and Employment of Unemployed Workers (guofa [1997] No. 10). The two
State Council notices served as the main catalyst for the bankruptcy
experiments, which started in 18 selected cities in 1994 and spread across
almost all other cities in China. See Shuguang, Li, A Deliberation
on The Key Issues of the New Draft Bankruptcy Law of Mainland China. <a href="#13a">Return to article</a>

<a name="14">14</a> Guangdong
Province has been a pioneer in local bankruptcy legislation. In August
1993, Guangdong promulgated the Guangdong Province Company Bankruptcy
Regulations. Several months thereafter, local bankruptcy rules were made at
the municipal level in Shenzhen of Guangdong Province, which is one of
China's four special economic zone at that time. See Shenzhen Special Economic
Zone Enterprise Bankruptcy Rules, effective as of March 1, 1994. <a href="#14a">Return to article</a>

<a name="15">15</a> The 11
chapters consist of General Rules, Bankruptcy Filing and Acceptance,
Bankruptcy Administrator, Bankruptcy Estate, Registration of Claims,
Creditors' Meeting, Reorganization, Mediation, Liquidation, Legal
Liabilities and Supplemental Rules. <a href="#15a">Return to article</a>

<a name="16">16</a> The
Partnership Enterprise Law, effective as of Aug. 1, 1997, provides for a
new business form of "partnership enterprise," which is similar
to the general partnership in the United States. All partners of such a
partnership enterprise are personally, jointly and severally liable for the
debts of the entity. Limited partnerships do not exist in China at this
time. §2, Partnership Enterprise Law. <a href="#16a">Return to article</a>

<a name="17">17</a> Under the
Sole Proprietorship Law, effective as of Jan. 21, 2000, sole proprietors
are personally liable for the debts of the entity. See §2, Sole
Proprietorship Law. <a href="#17a">Return to article</a>

<a name="18">18</a> This
exception covers approximately 2,000 SOEs designated by the State Council,
most of which are military and mining enterprises. The bankruptcy of these
SOEs will proceed pursuant to the existing administrative closure measures
for SOEs, which require that all bankrupt estates, including those that
secure creditors' claims, be applied to rehabilitate the employees
first rather than pay off creditors. The bankruptcy of these SOEs is
expected to be completed in the next three to five years. <a href="#18a">Return to article</a>

<a name="19">19</a> However,
only entities with a legal person status can be reorganized, which means
partnerships and sole proprietorships cannot be reorganized. <a href="#19a">Return to article</a>

<a name="20">20</a> §3,
Enterprise Bankruptcy Law. <a href="#20a">Return to article</a>

<a name="21">21</a> Equitable
insolvency is defined as the condition that exists when a debtor's
liabilities, fairly discounted, exceed its assets. It should be noted that
even finance and bankruptcy experts in China generally are not
sophisticated enough to properly use the concept of present value, which is
critical to the calculation of assets and liabilities under the equitable
insolvency test. It would be interesting to see how legislature will
clarify this test and how it will be applied in practice after the new law
is enacted. <a href="#21a">Return to article</a>

<a name="22">22</a> §24,
Enterprise Bankruptcy Law. <a href="#22a">Return to article</a>

<a name="23">23</a> In
contrast to the New Draft's administrator model, under the U.S.
Bankruptcy Code, the debtor-in-possession (DIP) continues to operate the
debtor's business by default unless it needs to be removed and
replaced by a trustee for cause. It has been debated among the drafters
whether the new bankruptcy law should introduce the same DIP default rule.
However, due to significant concerns about entrusting the bankrupt business
to the same group of people who often have contributed to, or even caused,
the bankruptcy of the business in the first place, the drafters decided not
to take that path. But the drafters did include a provision in the New
Draft that allows the incumbent management to continue to operate the
debtor's business under the supervision of the administrator. <a href="#23a">Return to article</a>

<a name="24">24</a> Chapter 3,
New Draft. Xinxin, Wang, "The New Bankruptcy Law About to Be
Unveiled," <a href="http://www.ccelaws.com/artclDtl.asp?566%7C%7Call">www.ccelaws.com/artcl…;, CCELAWS (Feb. 17, 2004). <a href="#24a">Return to article</a>

<a name="25">25</a> Li, supra. <a href="#25a">Return to article</a>

<a name="26">26</a> 11 U.S.C.
§§1121(b) and 1121(d). <a href="#26a">Return to article</a>

<a name="27">27</a> Wang, supra. <a href="#27a">Return to article</a>

<a name="28">28</a> "The
Breakthrough of Bankruptcy Law," Caijing
Magazine (June 2004). <a href="#28a">Return to article</a>

<a name="29">29</a> The chief
regulator of the banking industry is the China Banking Regulatory
Commission, or CBRC, which was divested from the People's Bank,
China's central bank, in March 2003. <a href="#29a">Return to article</a>

<a name="30">30</a> "Bankruptcy
of Financial Institutions Caused Concerns about Stability of
Society," SENEWS, <a href="http://www.sznews.com/n1/ca1001791.htm">www.sznews.com/n1/ca1001791.htm…; (June 22, 2004). <a href="#30a">Return to article</a>

<a name="31">31</a> Some
experts predict that an active restructuring market is likely to emerge
several years after the enactment of the new bankruptcy law. In order to
establish an effective bankruptcy system, however, several other related
laws, most notably the Company Law and the Securities Law, both of 1999,
will need to be revised. <a href="#31a">Return to article</a>

Journal Authors

James H.M. Sprayregen

Jonathan P. Friedland

Yong Wang

Journal Date

Wednesday, December 1, 2004 - 12:00

Bankruptcy Rule

2004