Distressed debt guide: Bankruptcy in China

Before 2007, the People’s Republic of China (PRC or China) had never had a comprehensive set of bankruptcy laws which covered all types of enterprises. There was a mix of rules and laws that varied in their application. In 1986 China introduced the first version of a bankruptcy law as a trial implementation to deal with bankruptcy cases of stateowned enterprises. It remained in use until 2007. For private enterprises, a Civil Procedure Law had been in use since 1991 but had only around 10 sections which related to bankruptcy matters. It was not only insufficient but it was full of loopholes. After 10 years in preparation, a new law was introduced in 2007.

The 23rd Meeting of the Standing Committee of the 10th National People’s Congress passed new insolvency legislation on 27 August 2006. The Enterprise Insolvency Law (‘EIL’) took effect on 1 June 2007.

The EIL applies to all entities that hold legal person status, including private companies, foreign enterprises, limited liability companies and companies limited by shares, as well as state-owned enterprises (SOEs).

With regard to financial institutions such as banks and insurance companies, the relevant authority of the State Council may apply for their restructuring or bankruptcy pursuant either to the EIL or other relevant laws. However, financial institutions are very important to the economy, as well as being commonly subject to unique concerns, such as special licensing, regulation and supervision rules that do not apply to other enterprises. That is why it would be preferable for the insolvencies of financial institutions to be dealt with through a separate law or through additional, clearly formulated regulations that would supplement the EIL.

The EIL offers three different types of bankruptcy proceedings: liquidation (bankruptcy), restructuring and settlement with creditors. It also allows for the conversion of restructuring and settlement proceedings into bankruptcy proceedings, which in turn can be terminated if the debtor or a third party has repaid all the debtor’s debts.

Under the EIL, a creditor, the debtor or, in the case of a financial institution, the relevant authority of the State Council may petition the People’s Court to bankrupt or restructure a debtor.

When a creditor has petitioned for the bankruptcy of a debtor, the debtor or an investor, whose capital contribution accounts for more than 10 percent of the debtor’s registered capital may petition the People’s Court for restructuring prior to a declaration of bankruptcy.

However, only debtor may apply for a settlement agreement and must do so before the court declares the debtor bankrupt. Once it receives an application, the People’s

Court has 15 days to decide whether to accept the bankruptcy petition.

This gives the People’s Court a great deal of leeway in deciding whether to accept a bankruptcy petition.

Once the People’s Court decides to assume jurisdiction, it must decide whether the debtor in question is insolvent. An enterprise must meet two criteria to be deemed insolvent:

• the enterprise must be unable to pay its debts when due; and
• the enterprise’s assets are not sufficient to repay all of its debts.

That is, the EIL seems to require an enterprise to meet both a liquidity test and a balance sheet test when determining insolvency, if the debtor wishes to make the application to court.

The EIL also refers to situations in which the enterprise is “likely to become insolvent”.

Whilst the legislation does not define what that means, it gives the court some leeway.

A creditor can petition where it can establish just one of the criteria – that the debtor cannot pay its debts as they fall due.

The EIL allows the People’s Court to impose a temporary stay on all ongoing civil proceedings and arbitrations relating to the debtor from the time the court decides to accept the bankruptcy petition (not the date of application) until the administrator takes over the management of the debtor’s property and assets. This in practice is meaningless, as the People’s Court is required to appoint an administrator upon accepting the bankruptcy petition.

Once a petition is accepted there is no period of protection in which a settlement or restructuring could take place – an administrator is appointed immediately.

In other jurisdictions, the period of the stay typically lasts from the date the petition for bankruptcy is filed until the declaration of bankruptcy and thereafter, or the last date for compliance with a restructuring plan in the case of a court-based restructuring or the dismissal of the bankruptcy proceedings.

It was perhaps a missed opportunity that a broader moratorium on creditor enforcement action was not incorporated in the EIL in order to give restructuring efforts some realistic hope of success by providing the debtor enterprise with a limited degree of breathing space from creditor actions to formulate a restructuring plan.

This partial chapter is one of 15 in The Definitive Guide to Distressed Debt and Turnaround Investing: A comprehensive resource for making, managing and exiting investments in distressed companies and their securities, a new book from PEI Media.

Edited by Probitas Partners, this guide provides investors and fund managers with valuable tools and practical guides, as well as case studies and best practices.