The Standing Committee of the National People’s Congress adopted the PRC Enterprise Bankruptcy Law (EBL) on 27 August 2006, after more than a decade of drafting and debate. The EBL will not become effective until 1 June 2007, however, allowing state-owned enterprises (SOEs) time to adjust to the new regulatory environment and for 2,000 SOEs to claim certain exemptions. The EBL will apply to the bankruptcy proceedings of all ‘enterprise legal persons’, including SOEs, with the exception of certain financial institutions.
EBL’s Key Features
The EBL sets out a sophisticated framework for bankruptcy and reorganisation proceedings, and will doubtless be a positive step forward in the evolution of China’s overall legal regime. Some key features are:
- applies to enterprise legal persons generally, including SOEs and foreign investment enterprises with the exception of certain financial institutions;
- right of a debtor to petition for bankruptcy liquidation, reorganisation or conciliation when it is unable to discharge its debts as defined by law;
- right of creditors to petition for involuntary liquidation or involuntary reorganisation of the debtor;
- appointment of an administrator by the People’s Court at the time of the acceptance of the bankruptcy case to take over daily management of the debtor’s property and business affairs under the supervision of the People’s Court;
- right of the creditors’ meeting to supervise management and handling of the debtor’s property, including the reorganisation plan;
- right to rescind fraudulent transfers occurring within 12 months of the acceptance of a bankruptcy application and preferential transfers occurring within six months;
- ability to initiate consensual work-out procedures;
- fast-track conciliation procedures; and
- provision for cross-border insolvency issues.
Scope of EBL’s Application
The EBL applies to the bankruptcy liquidation, reorganisation and conciliation of all enterprise legal persons, with exceptions for certain financial institutions such as commercial banks and insurance companies (special provisions for financial institutions are discussed further below). As such, the EBL will replace the current patchwork of legislation under which different legal regimes apply to individual bankruptcy or reorganisation cases based upon the nature and, to some extent, the location of the debtor. Under the EBL, if an enterprise is ‘unable to pay debts when due, and its assets are insufficient to pay its debts in full or it obviously lacks the ability to pay its debts’, then it may apply to the local People’s Court for the commencement of bankruptcy proceedings. It may also apply for reorganisation if it qualifies for bankruptcy under article 2, or if it is ‘obviously possible that it will lose the ability to repay its debts’. Creditors also have the right to apply for the commencement of (involuntary) bankruptcy or reorganisation proceedings against the debtor if a debtor is unable to pay its debts when due.
One question that remains unanswered by the EBL is how a creditor can establish that the debtor is ‘unable to repay its debts when due’. Earlier drafts included a presumption of such inability to pay when there was an actual failure to pay, but that has been deleted from the EBL. This leaves the local court with an apparently wide discretion regarding the acceptance of bankruptcy cases, which may be intentional. It is also possible, however, that an interpretation will be issued to add the necessary rules in this technically complex area. In practice, it could be useful for the courts to adopt a statutory demand notice system, such as the 21-day statutory demand notice regime in place in Hong Kong. This would have the benefit of lending a higher degree of certainty to the process of involuntary bankruptcy.
Role of Administrator and Creditors’ Meeting
Upon the acceptance of a bankruptcy case, the local People’s Court must appoint a bankruptcy administrator. The administrator can be an individual or an organisation, such as a law, accounting or bankruptcy liquidation firm, etc. If it is an individual, he must have professional liability insurance. The administrator has certain general powers, such as managing and disposing of the assets of the debtor and formulating a reorganisation plan. The administrator also has the power to petition the People’s Court to cancel certain suspect transactions, such as the cancellation of debts, transfer of assets without compensation, transactions at obviously unreasonable prices, and early repayment of debts not yet due, that have occurred within one year of the date of the bankruptcy petition being filed. In addition, the administrator may apply to the local People’s Court to cancel debts settled within six months of the bankruptcy petition if the enterprise was already bankrupt at the time.
The creditors’ meeting, on the other hand, has the right to supervise the administrator in the performance of its duties. The creditors’ meeting also has the power to decide whether to adopt a plan of reorganisation, conciliation or distribution of assets. The creditors’ meeting may also establish a creditors’ committee, to be comprised of representatives of the creditors and employees. The creditors’ committee shall have the right to supervise the management and the disposal of the debtor’s assets.
Rights of Secured Creditors
The EBL strengthens the rights of security creditors, giving them a priority right to repayment from the proceeds of the collateral covered by a valid security interest. At the same time, it reflects a compromise regarding certain contentious issues that emerged during the drafting process. In particular, after the second reading of the draft EBL in October 2004, a legal and political debate arose, reportedly over the question of creditors’ rights in bankruptcy proceedings. Under the October 2004 draft, unpaid workers were granted priority over other creditors, including secured creditors, in bankruptcy proceedings. The People’s Bank of China (PBOC) is understood to have strongly objected to this provision, and to have pushed for its removal. However, the absence of a comprehensive social security system and the large number of dislocated workers resulting from China’s rapid transition from a centrally-planned state-owned economy to a ‘socialist market economy’ made this provision especially contentious and politically charged.
The outcome of this debate was a victory for the PBOC and other secured creditors, as the EBL deletes the super-priority for labour creditors. However, as an apparent compromise, the drafters added a provision (article 132) that protects workers with respect to certain debts owed to them that arose prior to the promulgation of the EBL (namely, prior to 27 August 2006), by granting them priority distribution status even regarding property subject to a valid security interest. Thus, workers who qualify under this provision will have the right to be paid out of secured collateral before the secured creditor is paid. However, it should be noted that the significance of this provision will diminish with time as it only applies to historical labour credits, and not to newly created ones that arise after 27 August 2006. The scope of the priority includes workers’ salaries and medical benefits, handicap compensation, basic medical insurance and social security payments, and certain other amounts that should be paid to workers in accordance with law and administrative regulations.
Except in the special SOE situation discussed above, property subject to a valid security interest is outside of the bankruptcy property. The distribution order in bankruptcy liquidation, after payment of the costs of bankruptcy and debts of common benefit, is: (1) amounts owed to workers as salary, medical benefits, insurances and other legally required compensation; (2) other social insurance amounts not covered in (1) and outstanding taxes; (3) ordinary debts. To the extent that the value of collateral securing a debt is insufficient to fully repay such debt, however, the excess portion of the debt is treated as an ordinary debt.
Special Provisions for Certain SOEs
A further aspect of the drafting compromise regarding SOE issues can be seen in article 133, which provides that ‘prior to the implementation of the EBL, special matters with respect to the bankruptcy of state-own enterprises within the time limit and the scope stipulated by the State Council shall be handled according to regulations of the State Council’. This is an apparent reference to the so-called Capital Structure Optimisation Program (CSOP) that applies to SOEs in some 111 cities nationwide. Under the CSOP regime, decisions concerning SOE bankruptcy and reorganisation are subject to a central planning process, supervised by the National Development and Reform Commission. An important feature is the super-priority given to ’employee resettlement payments’, which are made either to individual workers to compensate for the loss of employment in the state sector, or used in a collective scheme to keep the workers employed. It appears, however, that once the EBL comes into effect, the CSOP regime will cease to apply to SOEs that have not already entered bankruptcy proceedings under its provisions.
Cross-border Insolvency
Provision is made for the recognition and enforcement by local People’s Courts of foreign court decisions or verdicts that involve the assets of a debtor where the assets are located within the territory of the PRC. However, this is subject to a number of restrictions, including that the enforcement is based upon an existing agreement or international treaty to which the PRC is a party, or on the basis of the principle of reciprocity, and that recognition and enforcement of the foreign verdict would not violate PRC law, nor harm national sovereignty, safety or social public benefit, and would not harm the interests of creditors in the PRC.
Foreign-invested Enterprise Bankruptcy
One remaining issue regarding the scope of application of the EBL is how it will be applied to foreign-invested enterprises (FIEs). While FIEs are enterprise legal persons (except for rare non-legal person ‘contractual joint ventures’) and thus should be subject to the EBL, the liquidation of FIEs is already governed by the Foreign Investment Enterprises Liquidation Procedures (the FIE Liquidation Procedures), promulgated by the foreign investment regulator (then the Ministry of Foreign Trade and Economic Cooperation, now the Ministry of Commerce, or Mofcom) on 9 July 1996. However, according to article 2 of the FIE Liquidation Procedures, if an FIE is declared bankrupt then the bankruptcy liquidation should be conducted in accordance with the relevant laws and regulations on bankruptcy liquidation. Thus, the FIE Liquidation Procedures would apply to non-bankruptcy liquidations of FIEs, and the EBL should apply to bankruptcy cases. Moreover, for matters upon which the FIE Liquidation Procedures are silent, the EBL could potentially be used to ‘fill the gaps’.
However, what is not clear is the role of the foreign investment regulator if an FIE is placed into bankruptcy. Under the FIE Liquidation Procedures, Mofcom must approve the application for the commencement of liquidation procedures. Historically, this approval has not been given automatically, especially when the FIE was a significant local employer. Whether the EBL will give FIEs a greater degree of flexibility remains to be seen. Conversely, FIEs may prefer to conduct voluntary liquidation under the FIE Liquidation Measures, since the liquidation process itself is a simple one that the investors control, as opposed to a process run by a court-appointed administrator. A separate but related question is whether Mofcom will expect to have a role in creditor-initiated involuntary bankruptcy proceedings against an insolvent FIE. Judging from the text of the EBL, it would not appear that Mofcom has any right to be involved, but how this will work in practice remains to be seen.
Financial Institutions
While the law does not automatically apply to the bankruptcy liquidation of PRC financial institutions, if a commercial bank, securities company, insurance company or other financial institution meets the requirements of article 2 of the EBL, then the financial regulatory authority of the State Council may apply to the local People’s Court to commence bankruptcy or reorganisation proceedings. The EBL also directs the State Council to determine the implementing measures for the bankruptcy liquidation of financial institutions on the basis of the EBL and other relevant laws and regulations.