China: Enter The Dragon - China Joins The Corporate Insolvency Arena

On 27 August 2006, following a twelve year process, the Standing Committee of China’s National People’s Congress approved a new enterprise bankruptcy law. It will come into effect on 1 June 2007.

The aim of the new bankruptcy legislation is to create a more effective framework for the management of insolvent entities and to accelerate China’s transition to a modern, market-based economy.

The new bankruptcy legislation will apply to both State-Owned Enterprises ("SOEs") and private enterprises (foreign and domestic).

The new framework will provide some certainty for secured creditors. In particular employee entitlements will no longer rank in priority to secured creditor claims.

The existing bankruptcy legislation

In China, "liquidation" means the dissolution of a solvent entity, whereas "bankruptcy" refers to the winding-up and ultimate dissolution of an insolvent entity.

The existing bankruptcy framework does not sufficiently deal with the complex issues that arise when managing an insolvent enterprise. A key limitation for secured financiers is the priority ranking of employee claims over secured assets.

Another major limitation is the existing legislation applies only to SOEs. Although SOEs make up a significant proportion of enterprises in China, there is currently no bankruptcy provision for private enterprises. Further, the existing legislation is not widely applied, with most insolvent SOEs allowed to continue trading for social policy reasons.

The bankruptcy process is also currently state controlled with a "bankruptcy committee" making all the decisions. In practice, creditors’ claims (including those of a secured lender) are often downgraded in favour of employees and other "local" creditors. The new bankruptcy legislation clearly states that secured creditors will rank first, employees second, unpaid taxes third and unsecured creditors fourth.

In recent years, a perceived need to provide confidence to international investors has led to Chinese officials promising that foreign creditors will receive priority payment in the event of an insolvency. However, the increasing level of claims from overseas creditors has meant that, in practice, this has not been uniformly implemented. The new legislation states all unsecured creditors will be treated equally, regardless of whether they are foreign or domestic.

The new bankruptcy legislation

The new bankruptcy legislation, to be administered by the courts, accords with standard international practice in better protecting lenders’ interests by giving secured creditors priority over secured assets, whilst unsecured creditors will continue to rank behind employee entitlements. To soften the social impact of the ‘demotion’ of employee entitlements, over 2,000 ailing SOEs will be allowed to enter insolvency before June 2007, guaranteeing access to existing government funds (estimated to be US$4.2 billion) for employee entitlements. In addition, pre-June 2007 entitlements will continue to enjoy priority.

The new bankruptcy legislation provides alternatives to the wind-up of an entity, being restructuring and conciliation. After the appointment of an administrator, but before the entity is declared bankrupt, the entity can apply for restructuring (where the entity will have the opportunity to submit a plan for rehabilitation of the business) or conciliation (where the entity can propose a compromise and settlement of its debts with creditors).

Under the new bankruptcy legislation, state financial regulators will also be able to step in and apply for compulsory bankruptcy orders against insolvent financial institutions such as banks, securities firms and insurers. This means creditors should be protected from losses that might otherwise be incurred if the financial institutions were left to decide for themselves whether they should file for bankruptcy.

The new bankruptcy legislation also provides for:

• an external administrator to supervise the bankruptcy process;

• an administrator to challenge certain reviewable transactions and investigate the entity’s property;

• a moratorium on claims;

• the appointment of a creditors’ committee;

• mutual set-off; and

• restrictions on managers of bankrupt enterprises from taking senior positions in other companies.

Some of the similarities and differences are illustrated below:

Moving forward

Despite being the world’s fourth largest economy and the largest recipient of overseas investment, China has lacked a transparent and workable insolvency regime. This has created uncertainty for foreign investors.

China is awash with underperforming businesses with an estimated US$400 billion in bad loans. A workable bankruptcy process should reduce the number of insolvent entities, with a flow on effect of improved economic efficiency, and provide creditors of insolvent entities with an avenue for recovering debts. This in turn should increase investor confidence. Coupled with the banking industry’s review of non-performing loans, the new legislation may make China the next target for opportunistic hedge fund managers seeking to invest in distressed debt.

Participants in the investment and lending markets in particular need to have a detailed understanding of the new bankruptcy law as it will affect how they manage legal and credit risk strategies. Similarly, the private equity market in China is rapidly expanding and creating enormous potential. Market players need to appreciate fully the potential shift in legal and commercial risk with the implementation of the new bankruptcy law.

Effective implementation will require considerable political will. However, there is no doubt the new bankruptcy legislation is a significant move towards an effective insolvency framework in China.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.