On Aug. 27, 2006, the People’s Republic of China passed a new bankruptcy law that will become effective on June 1, 2007. The concept of bankruptcy law is not new in Chinese law. The first bankruptcy law, called the “Qing Law,” dates from 1906, near the end of Qing dynasty. Before that, the issue was governed by an ethical precept, according to which “the debts of the father are to be paid by the son.” But the Qing Law had a short duration and was abolished with the fall of the empire around 1912. In 1935, under the Nationalist government, China enacted a bankruptcy law that is still enforced today in Taiwan.
The revolution of 1949 abolished all of the laws from the Nationalist period. When China began to open its doors to the West in the early 1980s, however, it was apparent that some sort of mechanism was necessary to permit companies – at this point, all state-owned – to liquidate. In 1986, a limited law was passed, and later extended in 1991, to the newly emerging enterprises that were not state-owned.
The most recent enacted bankruptcy law represents the incorporation of numerous sophisticated concepts and demonstrates change in an order and magnitude never before seen. There is an intense desire on the part of the Chinese to modernize their bankruptcy system, particularly since China has become a member of the World Trade Organization, but the authorities are mindful of the country’s cultural and social fabric and desire to take this step without fostering wholesale layoffs in the workplace. China has made tremendous strides in becoming a mature market economy, and while it is not there yet, this legislation represents a step forward in that journey.
The New Chinese Bankruptcy Law consists of 136 articles organized into 12 chapters, compared to the 43 articles and 6 chapters of the 1986 Bankruptcy Law.
The general provisions of the New Chinese Bankruptcy Law state that it “is formulated to regulate enterprise insolvency practice and activities, to fairly liquidate claims and debts, to protect the legitimate rights and interests of creditors and debtors, and to maintain the order of the socialist market economy.” This article explains the scope, application and controversy surrounding the New Chinese Bankruptcy Law.
The new law gives investors and creditors more certainty and confidence as to their ability to recover on their invested capital and claims in the event of a bankruptcy filing, but the passage of this law will not neutralize the legitimate concerns of foreign investors and lenders. In fact, there remains significant skepticism as to whether the law will be applied fairly and consistently.
One of the innovative aspects of the New Law is that it will apply to all kinds of enterprises and financial institutions. Thus, most of the country’s companies and enterprises, whether state owned or certain nonstate-owned enterprises (excluding entities such as partnerships), will have to abide by the unified Corporate Bankruptcy Law.
Another innovative aspect is that the new law allows for the possibility of a voluntary bankruptcy filing by the debtor as well as an involuntary bankruptcy filing against the debtor by its creditors. The New Chinese Bankruptcy Law also provides that a debtor, upon a voluntary bankruptcy filing, has the choice of selecting among reorganization, liquidation and conciliation.
Creditors are also given the ability to seek liquidation or reorganization of the debtor upon the filing of the involuntary bankruptcy proceeding.
In the first instance, under Article 2 of the New Chinese Bankruptcy Law an enterprise will qualify for bankruptcy if it “is unable to pay off the debts falling due, and its assets fail to meet the debts or it obviously lacks liquidity, it shall be liquidated in accordance with rules prescribed in this Law.” So, the New Chinese Bankruptcy Law contains an insolvency requirement similar to both common formulations of insolvency – “balance sheet” insolvency (in which total liabilities exceed fair value of assets) and “equitable” insolvency (in which the debtor is unable to pay debts as they come due).
Article 7 of the New Chinese Bankruptcy Law reiterates that the debtor may file a voluntary bankruptcy application according to the insolvency requirements discussed above in Article 2. Article 7 suggests an even lower standard of eligibility for an involuntary reorganization or liquidation application brought by creditors. Namely, Article 7 provides that “where the debtor is unable to pay off the debts as they become due, the creditors may file petition for reorganization or liquidation with the people’s court.” Thus, unlike voluntary debtor bankruptcy applications, only the equitable insolvency test applies to involuntary bankruptcy applications initiated by creditors.
Another innovative aspect is that, under current practice today in China, employee claims receive a priority over secured creditors. That is, if there are insufficient unencumbered assets to pay employee claims, then those employee claims would be paid out of the secured creditors’ collateral. The new law stipulates that from June 1, 2007, all insolvent enterprises will pay secured creditors and use other assets not earmarked as security to pay laid-off workers. The new law provides that upon its effectiveness on June 1, 2007, any employee claims that accrued, or were incurred prior to promulgation of the new law on Aug. 27, 2006, will continue to enjoy this priority over secured lenders. However, the new law also provides for any claims that accrue on or after Aug. 27, 2006, because an entity that files for bankruptcy under the new law will no longer enjoy priority over secured creditors’ collateral to the extent not otherwise satisfied out of the unencumbered assets of the debtor’s bankruptcy estate. If a bankruptcy case is commenced under current law and prior to June 1, 2007, any employee claims accruing after Aug. 27, 2006, will still enjoy priority over secured claims.
Once the people’s court accepts the bankruptcy filing, the court appoints an administrator, or “fa lu guan li ren,” who is in charge of taking over the debtor’s property business and managing its affairs. It is worth noting that the administrator is not appointed at the time of the filing of the case, but rather only after the court accepts the case.
Of interest will be the persons eligible to serve as administrators. The new law provides that “the specific measures on the designation of the administrator and on the determination of the administrator’s compensation shall be formulated separately by the Supreme People’s Court.” Thus, the details concerning compensation and qualification of administrators and whether licensed practitioners outside of mainland China can serve in this capacity will be subject to judicial rules and regulations to be promulgated.
The new law also embraces a modified notion of the concept of “debtor-in-possession.” In that regard, the debtor can request the court’s permission to manage its property and business under supervision of the administrator.
The New Chinese Bankruptcy Law provides for the recovery of various assets by the administrator for the benefit of the bankruptcy estate. Such recovered assets include the fruits of avoidable transfers, certain transfers to insiders, and even pending capital contributions from investors. Article 34 empowers the administrator to recover assets that are reacquired under Articles 31, 32, and 33, which set forth the administrator’s avoidance powers.
Article 32 provides for avoidance of debt payments by the debtor made during the six months before acceptance of the bankruptcy case, and made while the debtor was eligible for a bankruptcy case under Article 2, unless the specific payment “benefits the bankrupt property.”
Article 31 provides the administrator with the power to avoid transactions that occurred within one year before acceptance of the bankruptcy case that meet certain conditions indicative of constructive fraud. Namely, the administrator may “revoke” those transactions in the one year prior to the case where (1) property was transferred free of charge, (2) a transaction was conducted at an obviously unreasonable low price, (3) property was provided as collateral for unsecured debt, (4) a debt was paid off in advance that was not due, and (5) credits was gaven up.
Article 33 provides that certain other activities of the debtor “shall be void,” encompassing the hiding or illegal distribution of property. Specifically, Article 33 provides that “the following activities concerning property of the debtor shall be void: (1) hiding property or illegally distributing property for the purpose of avoiding the obligation of paying debts due and, (2) fabricating debts or recognizing inauthentic debts.
The new law provides that a choice of selecting among reorganization, liquidation and conciliation.
Reorganization provides for the restructuring of the enterprise’s debts, liquidation provides for the discontinuance of the enterprise’s operations and the sale of its assets and distribution of asset proceeds to creditors according to a modified allocation and priority scheme, and conciliation allows for a quick compromise of unsecured claims without the need for a protracted bankruptcy proceeding.
The new law contains many provisions similar to the U.S. Bankruptcy Code’s chapter 11 reorganization provisions. The debtor or administrator is required to submit a draft reorganization plan to the People’s Court and creditors’ meeting jointly in six months from the order allowing the reorganization. Among the plan provisions in the New Chinese Bankruptcy Law are classification and voting rights for creditors; cramdown on dissenting classes of creditors; inclusion of convenience class of creditors under the plan; prohibition against unfair discrimination of “members of the same credit group;” and treatment of equity interests “fairly and equitably.” Notably, under a reorganization plan, certain claims, including employee claims, will have to be paid off in full in the event a class of creditors dissents and refuses to compromise.
The new bankruptcy law is one of the laws that China is on course to implement so that it can enter into the international market economy and be a full-fledged member of the WTO. In this way China is trying to encourage investment in its economy. That means attracting outside investors and lenders. Lenders want to know what the exit strategy will be for an entity operating under Chinese law that becomes distressed. They want to know their rights and remedies in such a situation.
As in many countries with new bankruptcy laws, the Chinese judges will need experience and training to be capable of interpreting and applying the provisions of the new law in an appropriate way. Further, they will be guided by rules and regulations and future declarations of the Supreme People’s Court.