Reform of the Bankruptcy Regime in the People’s Republic of China

Introduction

The PRC’s ground-breaking legislation on bankruptcy – the PRC Enterprise Bankruptcy Law (“EBL“) – came into effect on 1 June 2007, after many years of drafting and discussion among the PRC legislature and various interest groups.

The EBL comprises 12 Chapters containing 136 articles, and is the first piece of bankruptcy legislation which uniformly governs State-Owned Enterprises (“SOEs“) and non-SOEs including collectively owned enterprises, private companies, Sino-foreign joint equity enterprises, Sino-foreign cooperative enterprises and wholly foreign owned enterprises. It does not cover individuals or partnerships.

This article will discuss some of the main features of the EBL and also briefly touch upon the Mutual Arrangement between Hong Kong and China on Reciprocal Enforcement of Judgments on commercial matters, as well as the new PRC Property Law which gave recognition to a floating charge.

Background

Before the enactment of EBL, there was no formal bankruptcy law in the PRC. The EBL is a major step forward in bringing the bankruptcy regime in the PRC closer to global standards. EBL introduced concepts which were previously non-existent in PRC bankruptcy regime, such as the appointment of an independent administrator and creditor committee, restructuring as an alternative to winding up and recognition of cross-border enforcement of bankruptcy rulings and judgments. However, the new provisions embodied in the EBL set out these new concepts in principle and are not specific in providing a procedure for implementation. Drafting of the new provisions is also relatively vague and this leaves much discretion to the PRC courts for interpretation or implementation. We will yet need to wait for implementation of the EBL in practice to see its true effects on addressing inadequacies of the old PRC bankruptcy regime under pressure from the increased demands of the PRC’s growing economy.

Main features of EBL

Application

Under the EBL, an application to wind up an entity will be made to the people’s courts. The applicant may be a debtor or a creditor, applying on the grounds that the debtor is unable to pay its debts as they fall due, has insufficient assets to pay off all debts or is obviously unable to pay or clear all debts. The court will have 15 days to determine whether it will accept the application.

Appointment of independent administrator

The appointment of independent administrator under the new law will be made by the debtor and relevant creditors. Many duties of the independent administrator must be exercised with the approval of the court and a separate creditor committee, if appointed. This contrasts with the previous situation where the bankruptcy process is overseen by a liquidation committee which is supervised by the court and whose members are usually made up of government officials and creditors.

Creditor committee

The creditor committee replaces the liquidation committee under the old bankruptcy regime. A creditor committee is made up of up to 9 members, including representatives of creditors and also at least one employee or labour union representative. The role of the creditor committee is to supervise the management, disposal and distribution of the debtor’s assets. Under the EBL, the administrator may not carry out certain acts, such as making a distribution of dividends or disposing of particular types of assets, without approval by the creditor committee.

Restructuring

Under the EBL, the debtor or a creditor or shareholder holding more than 10% of the debtor’s capital or liability may apply to the court for restructuring, as an alternative to winding up. Once the restructuring plan is approved by the court, the debtor may continue to manage the debtor’s assets under the supervision of an appointed administrator.

The administrator has 6 months (which could be further extended for another 3 months) to submit a restructuring plan. The plan must be approved by a majority of creditors, which represents two-thirds or more in terms of liability incurred by the debtor. If approved, the plan may then be submitted to the court for sanctioning. During this restructuring stage, there is a moratorium where any court proceedings against the debtor will be stayed and enforcement of security interest by a secured creditor is barred, except under exceptional circumstances.

Cross border recognition and enforcement

Under the old bankruptcy regime, the PRC has rarely recognised or allowed a foreign court’s judgment or ruling on bankruptcy matters to take effect if it involves assets located within the territories of the PRC held by a debtor.

Under the EBL, creditors of a non-PRC bankrupt company may enforce a foreign bankruptcy ruling or judgment against a debtor whose assets are situated in the PRC. Article 5 sets out three conditions which must be met: –

1. there are relevant treaties or reciprocal relations between such country and the PRC;
2. the bankruptcy proceeding outside the PRC does not violate the state sovereignty, national security and social public interest of the PRC; and
3. the bankruptcy proceeding outside the PRC does not harm the lawful rights and interests of the creditors in the PRC.

To put it in another way, there are two main hurdles which the creditor of a non-PRC bankrupt company will need to overcome.

1st hurdle – reciprocity

First, the creditor will need to establish that the country where the bankrupt company is wound up has a treaty with the PRC or will reciprocate the enforcement of a PRC ruling.

2nd hurdle – discretion by the PRC court

Second, a creditor needs to convince the PRC court that enforcement of the foreign judgment or ruling on bankruptcy does not harm the interests and rights of anyone in the PRC.

On its face, the conditions under article 5 are quite onerous, and the court has substantial discretion to interpret the conditions and decide whether they have been satisfied before permitting the recognition of a foreign court ruling. In essence, much will depend on the attitude which the PRC court will adopt when dealing with this second hurdle.

Furthermore, under article 5:-

“Any bankruptcy proceeding that originates under this Law shall be binding on all assets that are held outside the territory of the People’s Republic of China by the debtor”.

In other words, article 5 also seeks to extend to the assets of the debtor located outside of PRC. However, it is uncertain whether this unilateral provision of the PRC legislature will be given effect by a foreign court including ones from the UK, US or Australia.

The PRC has not adopted the UNCITRAL Model Law, which provides a framework for cooperation with foreign courts on cross-border insolvency proceedings. It is doubtful whether the US, the UK and other countries that have adopted the UNCITRAL Model Law will be willing to enforce a PRC bankruptcy ruling or judgment on the basis of article 5 and allow a PRC representative to pursue assets located in their territories.

In Australia, cross-border recognition of insolvency proceedings is largely governed by the Bankruptcy Act 1996 and the Corporations Act 2001 which generally provides that Australian courts must act in aid of courts of certain prescribed foreign countries. The PRC is not in the list of the prescribed countries. Therefore, it is unlikely at this stage that we will see enforcement of an Australian bankruptcy proceeding against assets located in the PRC and vice versa.

Antecedent transactions

An administrator may apply to the court to revoke specific types of transactions undertaken by a debtor leading up to bankruptcy. Such transactions include:-

1. Transfer of assets for no consideration;
2. Payment of debts which have yet to fall due; and
3. Embezzlement by senior management.

If the transactions are undertaken within a 1-year period leading up to acceptance by the court of a bankruptcy application, they can be voided or reversed by the court.

Management responsibilities and offences

The EBL imposes penalties against directors and senior mangers of the debtor who acted dishonestly or with lack of diligence and have thus contributed to the bankruptcy of the debtor.

In addition to imposition of civil penalty, individuals convicted of such behavior will be barred from assuming the position of director, supervisor or senior manager of any enterprise for 3 years.

The new law also provides for the imposition of fines on directors and senior management of the debtor who fail to assist in the bankruptcy process, including attending creditor meetings and providing information when requested by the Court to do so.

Priority of claims

Under the previous bankruptcy regime, bankrupt companies must pay in the following priority: liquidation expenses, employee claims and taxes, debts of the company and lastly the shareholders or capital contributors. The old law did not give recognition to secured interests.

The EBL specifically recognises the creation of secured interests. Under the EBL, secured creditors have payment priority to the extent of the value of the secured properties, while the unsecured portion is treated as a common claim. In effect, this means that claims by secured creditors are ranked above outstanding employee claims in contrast to the previous law and also other claims.

Under the new provisions, the order of priority for the payment out of realisations in a bankruptcy (subject to limited employee-related claims that arose before 27 August 2006) is as follows:

1. Secured claims;
2. Bankruptcy expenses;
3. Wages, pensions benefits and medical insurance premium;
4. Social insurance premium and taxes; and
5. Unsecured claims (including shareholders’ claims).

Arrangement between Mainland PRC and Hong Kong for Reciprocal Judgments in Commercial Matters

The PRC and Hong Kong entered into a bilateral agreement on reciprocal enforcement of judgments on commercial matters on 14 July 2006. The arrangement only applies to commercial contracts, which excludes judgments relating to matrimonial matters, bankruptcy and winding up.

Presently, a Hong Kong judgment is not enforceable in the PRC and vice versa. Thus, if a party has obtained a judgment in Hong Kong, it cannot enforce this judgment in the PRC without starting fresh proceedings in the PRC. When the new arrangement comes into effect (it has been signed, but we have yet to wait for legislative changes to bring this arrangement into effect in Hong Kong), parties can enforce a judgment obtained in Hong Kong against assets located in the PRC. However, there are many qualifications which limit the use of this arrangement. These are:

1. The arrangement will only apply to monetary judgments. It does not apply to injunctions or judgments involving specific performance.
2. The judgment must be a final judgment of a designated court. For Hong Kong, this includes the High Court, District Court and Court of Final Appeal. For the PRC, they include the intermediate People’s Court or above and some basic level People’s Court.
3. The arrangement only applies to commercial contracts which contain an exclusive choice of court clause (that is, a clause which specifically states whether a Hong Kong court or PRC court can assume jurisdiction over a dispute if it arises).

There are again many other uncertainties involved with implementation of this arrangement, and it is beyond the scope of this article to give a detailed analysis of such. In broad terms, it is unclear at this stage if the arrangement will create a practical and effective regime for the mutual recognition and enforcement of judgments between Hong Kong and the PRC given the numerous qualifications which need to be satisfied before the arrangement can apply.

PRC Property Law and creation of floating charge

The new PRC property law was passed on 16 March 2007 and will come into effect on 1 October 2007. It is the first piece of PRC legislation that comprehensively regulates the different types of rights which can be created or acquired over tangible property.

Definition of property and recognition of floating charges

Under article 1 of the new Property Law, the definition of “property” is greatly expanded and includes various types of security interests which can be created. For example, the new law provides that property which is not yet obtained (or does not currently exist), but which may be obtained in the future, can be mortgaged. This would address the issue of stock, thus providing what is in effect a floating charge.

Greater protection to secured creditors in bankruptcy proceedings

In light of the recent EBL giving priority to security holders, recognition of a floating charge will give a greater level of comfort to a secured creditor at the expense of others, including employees and unsecured creditors. This is because in bankruptcy cases, a floating charge may very often cover up to all assets and properties of the company. When a company becomes bankrupt and a secured creditor under a floating charge gets repaid first, there are usually no or very few assets left for general distribution to others including employees and unsecured creditors. However, we have yet to see if the effect in practice and whether this is an outcome that is desired by the PRC legislature. However, a secured creditor may have to bear in mind that, during the restructuring period, a security holder’s rights and interest in their secured property will be suspended, as discussed above.

Conclusion

In conclusion, the new EBL represents a significant development in the law and practice of bankruptcy proceedings in the PRC. However, it is uncertain what the true effects of the EBL will yet be for bringing the PRC more in line with international procedures on bankruptcy matters.

September 2007