China’s New Bankruptcy Law: An Introductory Note

China’s market-oriented reform has generally been successful since it started in the late 1970s. However, the transition of its corporate and financial sectors has suffered greatly from the absence of a functioning insolvency regime. While a trial bankruptcy law was adopted in 1986 and took effect in 1988, it covered only state-owned enterprises (SOEs), which now account for only about one third of the country’s total output. Non-state-owned enterprises have been left to a set of simple insolvency rules of the Civil Procedure. Even for SOEs, the 1986 law was inadequate and not frequently used. When the State Council (China’s cabinet) decided in 1994 to cope with the rising nonperforming loans owed by financially distressed SOEs through bankruptcy on a pilot basis, it had to put in place additional rules and procedures in the form of government policy for courts to follow, and carefully control the scale of the clean-up action. The pilot program was later expanded to cover over 1,000 SOEs every year, but it has never been able to get rid of a range of weaknesses, in particular, the weak protection of creditor’s rights due to heavy influence of some local governments on the legal proceeding, and the lack of effectiveness and efficiency of reorganization due to the inadequacy of relevant procedures. Recognizing the critical importance of a modern bankruptcy regime, the government started drafting a new bankruptcy law at the same time as it launched the SOE bankruptcy pilot program.

After 12 years of drafting, China’s parliament, the National People’s Congress (NPC), adopted the new law, the Corporate Bankruptcy Law (CBL) of People’s Republic of China, on Aug. 27, 2006. It will become effective on June 1, 2007, replacing the Enterprise Bankruptcy Law (trial) it adopted in 1986. This note provides a summary of key rules of the CBL, together with comments on some potential issues that may arise in enforcement.

Procedures and Coverage

The CBL contains 12 chapters and 136 articles. It puts in place three sets of procedures for insolvency proceeding: reorganization (chongzheng), reconciliation (hejie) and liquidation (pochan qingsuan). The reorganization procedure constitutes the mainstay of the CBL. Before entering any of the three procedures, however, a case may be closed by the court if the properties of the debtor are found insufficient to cover bankruptcy expenses.² Bankruptcy expenses and “commonly-benefiting debts³ ” shall be disbursed or repaid out of the debtor’s properties as soon as they are due.

While the 1986 Enterprise Bankruptcy Law covers only SOEs, the CBL has extended its coverage to all corporate entities, or “enterprise legal persons (qiye faren).” Enterprises such as sole proprietorships and partnerships that assume unlimited liabilities, as well as natural persons, will remain under regulation of the Civil Procedure. For financial institutions, Article 134 of the CBL provides the following: If a financial institution (commercial bank, securities company, insurance company, etc.) encounters a situation as specified by Article 2 (unable to repay due debt, and insolvent, see below), “financial supervisory agencies of the State Council” may apply to the court for reorganization or liquidation of the financial institution. However, the State Council is expected to set additional rules to govern the bankruptcy of financial institutions following the CBL and other laws. In terms of properties, the CBL also applies to debtor’s properties locating outside China.

Filing and Acceptance

Both debtor and creditor can file for bankruptcy. However, they differ in what they can file for and under what conditions. A debtor can file for all three procedures when it is (i) unable to repay debt due and (ii) its properties are insufficient to repay all debts, or it clearly lacks repayment ability. In particular, a debtor can file for reorganization when there is a “clear possibility of losing the ability of repaying debt.” A creditor can file for reorganization and liquidation only when the debtor is unable to repay debt due. (Articles 2, 7).

The court decides to accept or reject the case within a period specified by the CBL. When the court accepts a case, it simultaneously appoints an administrator, and informs known creditors and makes a public announcement about its acceptance of the case within 25 days. Once the case is accepted by the court, no debt repayment of the debtor to any one of the creditors is valid. (Article 10, 13, 14 and 16).

The CBL is not quite clear on rules and criteria with which the court decides on acceptance or rejection of the case. It is likely that Article 2, which states conditions under which debtor and creditor may file for a bankruptcy case, is the one the court is supposed to follow. However, this article per se does not seem to clarify. The full text of the article is the following: “a corporate legal person shall have its debts cleared up according to this law when it is unable (bu neng) to repay debt that is due, and its properties are insufficient to repay all debts or it clearly lacks repayment ability.” This invites questions as to what the court should do if (i) the debtor is able, but has failed to repay debt that is due; or (ii) the debtor is unable to repay debt that is due, but its properties are not found insufficient to repay all debts, and/or the debtor does not clearly lack repayment ability. Interpreting the Chinese word bu neng to mean “has failed” (which should be more precisely termed as “wei neng” in Chinese) does resolve question (i), but not (ii). The ambiguity of this part of the law leaves discretion to the court. According to Article 3, an insolvency case shall be heard by the court of the jurisdiction where the debtor is registered. 

Administrator

Chapter 3 of the CBL states that (i) an administrator shall be appointed by, and report to the court; and (ii) the administrator can be a liquidation panel comprised of relevant departments and agencies, or social intermediaries such as law firms, accounting firms, insolvency firms or qualified individuals in such intermediaries.

There has been debate with regard to who should be granted the power to appoint administrators: the court or the creditors’ conference. Argument against the power of the court was based on concerns that local courts may be heavily influenced by local governments and biased in favor of local debtors. The CBL has elected to grant the power to the court, and in the meantime stated that the creditors’ conference may request the court to replace an administrator if it believes the administrator fails to perform its function (Article 22).

The notion of a liquidation panel is largely inherited from the 1986 law. However, it appears much weaker in the new law in that it does not specify which departments and agencies and does not mention government. In addition, in the same article, the CBL states that those who have related interests (lihai guanxi, or conflict of interests) in the case shall not be appointed as administrator. It is then up to the court to decide if a government department or agency has such related interests in a case. Over the past decade, liquidation panels created according to the 1986 law, and comprised of local government officials, have played a key role in protecting local debtor SOEs against creditors in numerous cases.

Retroactive Protection of Properties

Chapter 4 of the CBL requires the court to invalidate the following transactions in response to a request of the administrator:

• Within one year before the court’s acceptance of the case, the debtor:
  
  • gave away properties for free,
  • conducted transactions at prices that are clearly unfair,
  • provided security to debt that was not secured previously,
  • repaid debt that was not due.
• Within a half year before the court’s acceptance of the case and when the debtor was unable to repay debt that was due, it repaid one or some of the creditors.

The chapter also states that the following transactions are invalid, without indicating a time frame:

• hiding or transferring properties of the debtor in order to escape from repayment obligation, and
• fabricating debt or accepting false debt.

These provisions reflect lessons learned in the past. If properly enforced, they should substantially strengthen the protection of creditors, especially minority creditors. The administrator is expected to reclaim properties lost in these transactions (Article 34). This can be difficult to enforce if the properties are gained, not by another corporate legal person, but a natural person, a sole proprietorship, or a partnership enterprise, due to the inadequacy of natural person insolvency rules. When employees are also creditors, implementation of these rules may face difficulties as well. For example, would it be a violation of the CBL if the debtor enterprise honored employee claims (see below for definition) within one year before bankruptcy?

Declaration and Verification of Claims

Chapter 6 of the CBL sets detailed rules regarding declaration of claims over the debtor. Creditors are required to declare their claims to the administrators within a period no shorter than 30 days and no longer than three months, to be specified by the court. However, a bundle of claims held by employees needs no declaration. The administrator shall conduct an investigation, produce a list of the claims and make it public. Employees may challenge the list and request that the administrator revise it, or they may bring the case to the court.

The bundle of employee claims that appear throughout in the CBL (Articles 48, 82, 103, 132) can be put in three categories: (i) wage arrears and unpaid contributions to individual pension accounts and basic medical insurance schemes; (ii) unpaid subsidies entitled by employees for medical care, injury and disability, and by surviving family members (fuxu feiyong); (iii) compensation entitled by employees according to rules of laws and administrative decrees.

The handling of employee claims has been a major issue for legislators. Even at the stage of declaration and verification of claims, the appearance of the bundle of employee claims raises practical issues. The first is related to the extent to which this bundle of claims is clearly defined. While category (i) may not be a severe problem, categories (ii) and (iii) can be sources of dispute. In category (ii), the issue is the point of time by which the entitlement of the subsidies is calculated. Take, as an example, a SOE worker who suffered from injury at work and has been entitled to a stream of subsidies before his retirement age. In the event of privatization, the common practice has been a lump-sum payment to the worker that represents the present value of his entitlement in the future. In the event of a bankruptcy of his SOE, it is not completely clear if his claim shall be defined as the unpaid amount of the subsidy by the time of bankruptcy, or including the total present value of his future entitlement. In category (iii), the issue is a question of which rules of laws and decrees are to be applied, and the extent to which these rules define the compensation in an unambiguous and undisputable manner.

In the event of a dispute regarding the validity of any claim, verification becomes a key for the proceeding to move forward. In this regard, the CBL (Article 61) only allocates the task to creditors’ conference without more rules. This can be a problem in practice because the creditors’ conference cannot function before the validity of each claim, including its amount, is verified.

Creditors’ Conference

Chapter 7 of the CBL sets rules regarding the functioning of creditors’ conference. First, it grants the following power to creditors’ conference:

1. verifying claims
2. requesting the court replace the administrator and reviewing expenses and remuneration of administrator
3. supervising the administrator
4. electing and replacing member of the creditors' committee
5. deciding on whether the debtor continues or stops its operation
6. approving the reorganization plan
7. approving the reconciliation plan
8. approving the administration plan for debtor’s properties
9. approving the plan of selling bankruptcy properties
10. approving the distribution plan of bankruptcy properties
11. other power granted to it by the court.

Second, it puts in place a general rule of decision-making. Unless specified by other rules of the CBL, a decision of the creditors’ conference shall be taken when (i) more than half of the creditors with voting power vote to support it, and (ii) they represent more than half of the claims that are not secured with property. Individual creditors may challenge such a decision by filing a request to the court within 15 days. Otherwise the decision is binding on all creditors. Secured creditors do not have the power to vote on items g (reconciliation) and j (distribution of bankruptcy properties in liquidation) unless they give up their priority.

Third, the CBL requires representatives of employees and trade union of debtor enterprise to be present in the creditors’ conference and speak on relevant issues.

Fourth, the creditors’ conference may elect to create a creditors’ committee. The creditors’ committee shall consist of no more than nine members, including one representative of employees and trade union of debtor enterprise. Its functions are specified as:

• supervising administration and disposal of debtor’s properties,
• supervising distribution of bankruptcy properties,
• proposing to hold the creditors’ conference, and
• other functions authorized by the creditors’ conference.

With the exception of reorganization (item f) and reconciliation (item g), the general decision-making rule of the creditors’ conference, i.e., “two half’s” majority, applies for all decision-making, including adoption of the distribution plan of bankruptcy properties in the event of liquidation. The decision-making may easily be dominated by employee claimholders and large financial creditors. For example, if there are unpaid contributions to individual accounts of pension and medical insurance schemes, it is likely that all employees become creditors with voting rights, and it may be easy for them to veto a decision by organizing a majority of more than half of the number of creditors, unless the term “creditors with voting rights” in Article 64 is interpreted differently. For financial creditors such as banks, it is often easy for them to assemble a majority of more than half of the amounts of claims. A deadlock is also possible, at least in theory: employee claimholders and financial creditors each have majority in the number of creditors and amount of claims, respectively, and veto the proposal supported by the other side.

Reorganization

Initiation. Reorganization can be initiated by either the debtor or a creditor. When a creditor or group of creditors has filed for liquidation and the case has been accepted by the court, the debtor or any of its shareholders that contributed 10 percent of its paid-in capital may apply for reorganization before the court declares bankruptcy of the debtor (Article 70). Again, the court is expected to accept or reject the application for reorganization (Article 71), but the rules and criteria on which this decision is made are not clear. This could be a serious problem if the court is captured by either debtor’s or creditor’s interest. In the worst scenario, liquidation can be delayed by nine months if the debtor manages to bring the case to the reorganization track and its reorganization plan is rejected by the creditors’ conference.

Debtor’s operation. During the period of reorganization, with approval of the court, the debtor may continue to manage its properties and operation under supervision of the administrator (Article 73). The debtor may collateralize its properties for new debt it assumes during reorganization if deemed necessary for continuation of its operation (Article 75). Shareholders of the debtor shall not claim investment return during this period (Article 77). The court can terminate a reorganization and declare bankruptcy of the debtor if (i) the operational and financial conditions of the debtor worsen and there is little possibility for the enterprise being turned around; (ii) the debtor engages in cheating, reducing its properties deliberately or other actions that are clearly detrimental to creditors; or (iii) the debtor has behaved in such a way that the administrator cannot perform its function (Article 78).

Reorganization plan. The debtor or the administrator is expected to submit to the court and the creditors’ conference a reorganization plan within six months after the court accepts an application for reorganization, which can be extended by the court for another three months. Failure to submit a reorganization plan results in the termination of reorganization and declaration of bankruptcy (Article 79). The reorganization plan should include a plan of business operation, classification of claims, plan of restructuring and repayment of claims, and other plans that facilitate the reorganization of the debtor (Article 81). There is no mention of debt-equity conversion, but presumably this can be included in the restructuring and repayment of claims.

Notably, Article 83 of the CBL stipulates that the reorganization plan shall not propose any forgiveness of or discount on social insurance arrears except for those that contribute to individual accounts of pension and basic medical insurance of employees. This presumably refers to the payroll taxes that finance the social pooling pillars of the pension and medical insurance schemes, as well unemployment insurance and work injury insurance. Accordingly, holders of such claims shall not vote in the creditors’ conference when it approves the reorganization plan. Interestingly, this gives unpaid payroll taxes a higher priority than general tax arrears, for which forgiveness and discount can be proposed in reorganization plan and their claimholders can vote to approve or reject it.

Decision-making rules. The decision-making rules of the creditors’ conference with regard to reorganization plans are the most complex procedures in the CBL. They have the following components.

1. Grouping of claimholders (Article 82, 85). Claimholders are divided into five groups according to the nature of their claims.
   
   1. secured claims
   2. employee claims as mentioned above
   3. tax arrears
   4. ordinary (putong, or unsecured) claims
   5. ownership stakes, when their restructuring is involved in the reorganization plan.
2. Decision-making (Article 84, 86). A group approves the reorganization plan when (i) more than half of its claimholders vote in favor of it and (ii) they represent more than two thirds of total claims of the group. The reorganization plan is approved by the creditors’ conference only when every group approves it.
3. Resolution of disagreement among groups (Article 87). If one or more groups reject the reorganization plan, the debtor or the administrator may request that the court approve it if the reorganization plan meets the following conditions.
   • Secured claims are fully repaid, or their group approves the plan.
   • Employee claims and tax claims are fully repaid, or their groups approve the plan.
   • Recovery rate of ordinary claims is no lower than the one that would have realized should the debtor be liquidated at the time when the reorganization plan is voted on, or their group approves the plan.
   • The proposed reorganization of ownership stakes is fair and just, or this group approves the plan.
   • The plan treats all members of each group in a fair manner, and the proposed order of priority does not violate the one set in Article 113 (the one for liquidation).
   • The proposed operation plan is feasible.

Put together, the court may rule to approve the reorganization plan in three kinds of situations: (i) one or more groups reject the plan when their interests are not hurt; (ii) the treatment of members of any one group is unfair and the order of priority of Article 113 is not observed; and (iii) the plan is judged as feasible. The first situation may not be a big problem if specific rules are spelled out with regard to determination of liquidation value of the debtor’s properties, and “fair and just” treatment of ownership stakeholders. The second situation should also not be difficult to deal with. However, the third situation would put the court in a position to judge the feasibility of the plan, which requires high capacity of the court or more specific rules that can be difficult to formulate.

Closure of reorganization proceeding. The reorganization proceeding can be closed in three events. First, the plan is approved, in which case the debtor implements the plan and the administrator supervises the implementation in a pre-specified period of supervision. Second, the plan is rejected and the court declares bankruptcy of the debtor. Third, the debtor is unable to or fails to implement the plan, in which case the court may rule to terminate the implementation in response to request of the administrator or other stakeholders and declares bankruptcy of the debtor (Article 87, 88, 93).

Reconciliation

Reconciliation, in which the debtor and creditors negotiate and agree on a settlement so that the bankruptcy proceeding is closed, can only be initiated by the debtor. Again, the court may accept the request “if it is line with rules of this law,” but it is not clear what the rules are.

The creditors’ conference accepts a reconciliation agreement when more than half of creditors, representing two thirds of claims, vote in favor of it. Secured creditors do not vote unless they give up their priority. If the proposed agreement is rejected by the creditors’ conference or a decision of the creditors’ conference is overturned by the court, the case goes to liquidation track.

Liquidation

The most significant change of the CBL compared with its 2005 draft is its treatment of employee claims vis-à-vis secured claims, particularly in the case of liquidation. While Article 127 of the 2005 draft granted employee claims a higher priority over secured creditors, the adopted law has three articles to resolves the issue.

• Article 109 grants priority to secured claimholders with regard to the properties that have been set as collaterals.
• Article 113 sets up the following order of priority, after deducting bankruptcy expenses and commonly-benefiting debts:
  
  1. employee claims as described above
  2. all other unpaid contributions to social insurance schemes and tax arrears
  3. ordinary claims.
• Article 132 creates a cut-off: If the employee claims occurred before the date of adoption of this law (i.e., Aug. 27, 2006) and they do not receive full repayment under Article 113, the remainder shall be repaid with properties that are collaterals under Article 109 before secured creditors are repaid. There is not an end date on this clause.

Compared with its 2005 draft, the CBL upholds the priority of secured creditors over other claimholders, including employees. The grandfathering of employee claims occurring before Aug. 27, 2006, seems a practical compromise, despite the possible cost of institutional distortion: If a creditor accepted a debtor’s properties as collateral before the adoption of this law, and the debtor happens to run into bankruptcy with its uncollateralized assets insufficient to honor employee claims, the CBL would appear unfair to the creditor. It is therefore important to put in place explicit and clear rules governing the determination and verification of employee claims to limit the institutional cost and make them predictable as much as possible. While the issue of the priority of employee claims vis-à-vis secured claims will fade away in the foreseeable future, the determination of the amounts of employee claims and their verification will, without additional rules, remain a complicated issue in the enforcement of the CBL.