China Enacts New Bankruptcy Law
 
October 23, 2006
 
Kai Yang - Beijing

On August 27, 2006, the Standing Committee of the National People’s Congress passed the Enterprise Bankruptcy Law (New Bankruptcy Law). The New Bankruptcy Law will come into force on June 1, 2007, to replace the Interim Enterprise Bankruptcy Law (Old Bankruptcy Law). It took over 12 years to complete the drafting process; the enactment of the New Bankruptcy Law reflects China’s efforts to modernize its bankruptcy regime. The following are noteworthy aspects of the New Bankruptcy Law.

Applicability

The New Bankruptcy Law applies to all legal persons including state-owned enterprises (SOEs), private companies, foreign-invested companies and joint-stock companies. By contrast, the Old Bankruptcy Law (enacted December 2, 1986, and effective November 1, 1988) merely applied to the SOEs. The Old Bankruptcy Law did not provide workable guidelines for companies and courts, therefore failing its goals of protecting the rights and interests of creditors, debtors, investors and employees of bankrupt companies.

To effectively resolve a bankruptcy case, the court must also refer to another set of rules, the bankruptcy provisions contained in the Law of Civil Procedures (enacted April 9, 1991, and effective as of the enactment date), the interpretations on the Implementation of the Law of Civil Procedures (issued by the U.S. Supreme Court on July 14, 1992), and other interpretations issued by the Supreme Court on bankruptcy proceeding (collectively, the Bankruptcy Procedural Rules). Moreover, since 1994, the State Council has promulgated a set of policies and administrative rules to effectively establish a policy bankruptcy system for the SOEs. Under such a system, the welfare interests of employees, including unpaid wages, pension contribution, medical insurance premium and workers’ compensation, were given preference over secured debts in the distribution of the bankruptcy estate, despite the requirement under the Old Bankruptcy Law and Bankruptcy Procedural Rules that secured creditors be given the first priority.

The applicability of the New Bankruptcy Law is limited. It does not apply to natural persons, sole proprietorships, partnerships and other non-legal-person entities. It has been clarified that the New Bankruptcy Law applies to financial institutions, but the bankruptcy of financial institutions is subject to special provisions. In addition, the State Council is delegated with the authority to promulgate the implementation rules on the bankruptcy of financial institutions. The Policy System will continue to apply to the bankruptcy proceedings of the SOEs commenced prior to the effective date of the New Bankruptcy Law.

Bankruptcy, Reorganization and Settlement

The New Bankruptcy Law sets out a threshold insolvency test to trigger the bankruptcy proceeding, which includes: (1) a debtor is not able to pay its debts which are due; and (2) it does not have sufficient assets to pay off all its debts or clearly lacks the ability to pay its debts.

The New Bankruptcy Law further provides three options for a debtor that meets the insolvency test: (1) reorganization; (2) settlement; and (3) liquidation and bankruptcy.

It appears that a debtor may directly apply for any available relief, but bankruptcy is the last resort where reorganization or settlement fails. It is not clear whether the debtor can apply for both reorganization and settlement. Under the New Bankruptcy Law, the debtor is entitled to submit a reorganization application or settlement application at any time prior to the court declaring it bankrupt. Under the Old Bankruptcy Law, settlement is a part of the reorganization process and only the overseeing government agency can apply for reorganization for the SOEs.

The court will appoint an administrator upon the commencement of the bankruptcy proceeding. Under the New Bankruptcy Law, the administrator is responsible for taking over the debtor’s assets, records and books, making decisions on the debtor’s internal matters and necessary expenditures, managing and disposing of the debtor’s property, and representing the debtor in lawsuits, arbitrations and other proceedings. The creditors’ meeting may request the court to replace the administrator if it is determined that the administrator is unqualified. The Supreme Court has the authority to issue interpretations on procedures for appointing the administrator and determining its compensation.

Priority of Distribution

It has been wildly applauded that the New Bankruptcy Law reinforces the priority of secured creditors as to the specific collaterals. Some argue that this provision, which clarifies that the secured creditors be given priority over workers, effectively ends the Policy Bankruptcy System.

The distribution of bankruptcy assets should be carried out based on the following levels of priority: (1) bankruptcy expenses; (2) unpaid wages and other welfare payments; (3) other unpaid social insurance premiums and tax; and (4) unsecured claims.

Prevention of Bankruptcy Fraud

The Old Bankruptcy Law was greatly criticized for being easily abused and circumvented. By contrast, the New Bankruptcy Law contains specific provisions to prevent fraudulent transfer of assets.

Upon the commencement of a bankruptcy proceeding, the debtor is prohibited from making payment to individual creditors. In regards to the payment made by the debtor six months prior to the commencement of the bankruptcy proceeding, the administrator is empowered to avoid such a transaction if the debtor was insolvent at the time,

The administrator has the right to avoid one of the following transactions executed by the debtor within one year prior to the commencement of the bankruptcy proceeding:

• transfer of assets for free

• the price is clearly under value [this bullet is not consistent with the rest of the list; the other bullets are describing an action]

• provide security for unsecured debts

• pay off debts before their due date

• abandon debit claims

The administrator is also authorized to recover the unpaid capital contribution of the debtor’s shareholders, in addition to the unlawful gains of the debtor’s directors, supervisors and senior officers.

To ensure a fair bankruptcy proceeding, the New Bankruptcy Law imposes certain duties on the debtor’s officers:

• take proper control of the debtor’s assets, seals, records and books

• work as required by the court or administrator

• attend the creditors’ meeting and answer questions

• remain at the residence unless given the court’s permission to leave

Where the debtor intentionally injures the creditors’ interests, its legal representative and any other officers in charge may be liable for damages.

Outlook

It suffices to say that the enactment of the New Bankruptcy Law will become the cornerstone of China’s bankruptcy regime. Based on the framework established by the New Bankruptcy Law, it can be expected that the legislature, the State Council and the Supreme Court will continue to develop the rules to address specific aspects of the regime. Foreign creditors will gain confidence in the safety of their funds, as the New Bankruptcy Law contains a number of provisions designed to protect the creditors’ interests.

For more information, e-mail Kai Yang at kai.yang@hklaw.com or call toll free, 1-888-688-8500.