New China

By all accounts the Chinese Bankruptcy Law needed reform, and on June 1, 2007 the new bankruptcy law will take effect. Although the old law will still apply to state-owned enterprises (SOEs) until 2008,¹ some experts believe the SOE exception for SOEs will be extended beyond 2008.

When the new bankruptcy law does begin to apply to SOEs, China will have, for the first time, a bankruptcy law that applies to both SOEs and certain private enterprises. The old law only applied to SOEs. However, the New Chinese Bankruptcy Law does not apply to partnerships or sole proprietorships, nor does the new law create a structure for personal bankruptcy. Currently the National People’s Congress (NPC) has approved more than 2,000 unproductive SOEs to file before the exception period ends.

This article will examine the changes incorporated in the New Bankruptcy Law as the new law relates to SOEs and how those changes remedy the problems exposed when an SOE filed for bankruptcy under the old law, especially as the law relates to workers and foreign investors/creditors.

The Need for a Change

The examples of the failures of the old law are numerous and glaring for both creditors and the workers who have counted on an ailing entity. Under the old law, workers’ claims for wages were given priority over all other creditors – including secured creditors. However, under the old law a SOE only filed for bankruptcy as a final result after an attempted reorganization outside of the judicial system. Once a SOE filed for bankruptcy, the law only provided a structure for liquidation. However, the liquidation of a failed enterprise still left the workers with almost nothing.

The restructuring policy for ailing SOEs was not supervised by the courts, but the national restructuring policy required either local governments to raise money to cover unpaid compensation (including retirement compensation) or the workers trade the right for this compensation for stock in the SOE and be able to retain their jobs. While the restructuring plan was required to seek the workers’ representative’s approval, this was often times illusory, as the representative was likely a local party member and there was not true independence between the representative of the union and the management who were also party members. This left workers with the unenviable choice of either accepting the proposed liquidation value for buying out the employee’s years of service (unpaid compensation and accrued retirement); or accepting stock in the failed company, accepting new labor contracts and avoiding liquidation, but retaining their jobs. Usually neither of the options provided the laborers with enough compensation to provide for a minimum standard of living.² Of course, under the old law if this is what the worker’s class received – the creditor with the highest priority – all other creditors received nothing.

Even when there was potential for creditor recovery beyond the worker’s class, the old bankruptcy law provided an efficient structure to promote recovery. Under the old law, the failing SOE was able to avoid creditor’s claims, and the lack of the disclosure of assets allowed SOEs to assert that there were no assets while the company siphoned assets back to the state. The bankruptcy of the Zhu Kuan Development Co. Ltd. (ZKD), the second largest bankruptcy in China’s history, is a well-documented case showing how a debtor was able to use the old bankruptcy law to reduce the creditors’ recovery.

ZKD was a window company to attract investment in Zhuhai City, adjacent to Macau, and was wholly owned by the Zhuhai Municipal Government (ZMG). ZKD, for the most part, was implicitly backed by the ZMG, and when it suited its purposes, it was explicitly backed by the government. Beginning in 1994, ZKD began to raise enormous amounts of money from foreign investors eager to develop a presence in China through stocks and bonds. ZKD’s business activities were very diverse – principally investing in real estate in Zhuhai, Hong Kong and Macau, but also investing in tourism ventures, theme parks, infrastructure and utilities, among numerous other enterprises.

With the Asian Financial Crisis at the turn of the millennium, and mismanagement, it became obvious that ZKD’s liabilities greatly surpassed its assets. The stock plummeted and ZKD was unable to make the necessary payment on the bonds floated. ZMG, on behalf of ZKD, attempted to restructure, offering creditors 40-61 percent of the money owed. Within a year, the settlement offers had dropped to 20 percent, but creditors were not able to force ZKD into an involuntary bankruptcy based on the old law. Due to sovereignty concerns, Hong Kong and Macau did not allow a bankruptcy filing against ZKD until 2003. When ZKD was declared bankrupt in Macau in 2004, ZKD became the first investment arm of the Chinese government ever to be declared bankrupt by either Hong Kong or Macau. However, the court was only able to provide the creditor’s relief from assets located in Hong Kong and Macau. This was of little relief since in 2001 ZKD had begun transferring assets back to either mainland China or to ZMG.
 
In 2002, ZMG began to requisition ZKD’s land use rights. In China, all land is owned by the state, and those using the land are merely granted land use rights and the state has fairly broad leeway to requisition the land. In attempt to challenge the forfeiture of certain properties from ZKD to ZMG and gain disclosure of ZKD’s records, bankruptcy was filed against ZKD in China. The court fee charged by the judge was 0.5 percent of the value of ZKD’s assets. The judge ignored the statutorily imposed 100,000 yuan ceiling on bankruptcy cases. On appeal, the case was reclassified as an administrative case and the fee for administration was reduced to 100 yuan. However, there were several delays in the case and it was not until July 2005 that creditors settled for a return of almost 40 percent.³

The ZKD case showed many weaknesses in the old bankruptcy law, including the lack of an independent judiciary, lack of professional judges, lack of applicable laws, lack of accountability, high risks when SOE assets are located in the province of the SOE, forum shopping and lack of disclosure. The New Bankruptcy law attempts to remedy several of these problems.

The New Bankruptcy Laws Attempt to Close the Loopholes

Arguably, the most important aspect of the New Bankruptcy Law, as it applies to SOEs, is that there are now three options for a SOE in a bankruptcy proceeding: liquidation, reorganization or compromise. All of which are under the supervision of the court as opposed to only liquidation being under the supervision of the court. This will give both secured/unsecured creditors and employees a chance to evaluate their options with much more disclosure.

The new law also promotes the use of an administrator (e.g. a professional service firm or attorney, etc.) to guide the company through the proceedings. This reduces the potential waste of assets that would occur under the old law while the debtor was attempting to reorganize. The new law also allows the debtor to remain in possession in certain cases, but this appears to be meant as the exception, not the rule. The administrator or DIP must determine whether to accept or rescind outstanding contractual obligations, as well as enhance the current assets and avoid previous transactions, much like the powers available in a bankruptcy proceeding in the United States.

Additionally, the new bankruptcy law creates civil liability for breach of the duties of loyalty and diligence by the duties directors if appropriate. The creation of this standard of corporate governance would certainly have limited the abuses or created repercussions in the ZKD case.

The other major change is the improvement of creditor’s rights. Under the old law, workers’ claims had priority over all other claims. Now secured creditors have priority to the extent of their security, then bankruptcy expenses, then unpaid salaries and social insurance premiums, then taxes, and finally unsecured creditors. This allows creditors to foreclose or demand adequate assurances if it appears likely that the security will suffer damage or diminution in value. While employees are likely to suffer from the change in priority, the added transparency of reorganization should more than offset the harm when compared to the old law.

The reorganization option of the new law contains many elements of a chapter 11. A plan must be submitted within six months, creditors must be divided into different classes, and each class must approve the plan by a majority of the creditors in number and two-thirds in value. Secured creditors are not entitled to vote so long as they are paid in full. A dissenting class can be crammed down. If secured creditors, workers and the tax authority are paid in full, the unsecured creditor is no worse off than if the debtor was liquidated, and the plan in practical. The ability to reorganize and cram down should certainly save some SOEs that would have been liquidated under the old system.

However, several of the issues that created the workers’ and creditors’ problems under the old law still exist. Most notably, the lack of an independent judiciary, the judiciary reorganizing SOEs at the municipal level, will still have close ties to both the municipal government and potentially the SOE itself. The new laws give the judiciary discretion for 15 days after the filing of the petition to determine whether to accept or reject the case. If not accepted within the time period, the case will be deemed rejected and reorganization will have to occur in the same manner it occurred under the old law. Additionally, the new law does not create a specialized judiciary to handle bankruptcy cases, so the cases will continue to be handled by the same judges who have handled them before and may not have the time or specialized experience necessary to oversee a reorganization or liquidation.

Another important issue is the lack of cross-border insolvency. The new law purports to extend to the debtors’ assets overseas, dependent on cooperation by the foreign courts. The law also provides foreign bankruptcy proceedings may be binding on the China-based assets of a debtor. However, there are large exceptions that allow the Chinese court to not recognize a foreign court’s judgment: there must be reciprocity in the recognition of bankruptcy proceedings, the proceedings must not contravene Chinese public interests, and the legal interests of Chinese creditors must not be impaired. Based on these exceptions, it is unlikely that the new cross-border insolvency would have resulted in a greater recovery for the creditors of ZKD in the Macau bankruptcy proceedings.

The framework for an international standard for bankruptcy proceedings is now in place if properly implemented. However, based on questions regarding implementation as the new law relates to SOE even secured creditors should not expect the same returns as a secured creditor in a bankruptcy proceeding in a more established bankruptcy jurisdiction. Based on this uncertainty, the creditors who should be most comfortable in a Chinese bankruptcy proceeding are those that have and can utilize guanxi to ensure enforcement of the bankruptcy law and place pressure on municipal governments.⁴