An Overview of China's New Bankruptcy Law

After a long gestation China's new Enterprise Bankruptcy Law (Bankruptcy Law) will become effective on June 1, 2007. The Bankruptcy Law was adopted by the Standing Committee of the 10th National People's Congress on Aug. 27, 2006, and will significantly change how Chinese and foreign entities analyze bankruptcy issues. The old law, the State Enterprise Bankruptcy Law (Trial Implementation), issued in 1986, regulated the bankruptcy process only for State-Owned Enterprises (SOEs) and, by the mid-1990s was seen to be in serious need of amendment.

The Bankruptcy Law is the first standardized bankruptcy law in China, replaces the old law and myriad other regulations, and removes some of the administrative uncertainty that existed under the former sets of regulations. The Bankruptcy Law applies to all enterprises 'with legal person status,' including SOEs, private companies, limited liability companies, companies limited by shares, and foreign-invested enterprises (FIEs). Individuals and partnerships are not subject to the new Bankruptcy Law.

The scope of the Bankruptcy Law is limited in two circumstances:

a) Financial institutions whose bankruptcy could harm China's economy may have their bankruptcy directly administered by relevant Chinese government authorities; and

b) SOEs that announce their bankruptcy prior to June 1, 2007 may receive assistance in the bankruptcy process from the Chinese government and must pay employment-related claims before any secured or unsecured creditor, a continuation of policy bankruptcies.

Starting the Process

Under the Bankruptcy Law, either a debtor or a creditor can file a bankruptcy application with the relevant People's Court. A debtor may make an application if it is:

a) Cash-flow insolvent;

b) Balance-sheet insolvent; or

c) 'Obviously' insolvent. A creditor may make an application only if its debtor is cash-flow insolvent.

The People's Court must decide within 15 days of receipt whether to accept such application. Debtors may contest an application made against them, and either a creditor or debtor may contest the rejection of a bankruptcy application. If accepted, the People's Court is to:

a) Notify the debtor and all of its known creditors of such acceptance; and

b) Appoint a bankruptcy administrator, as discussed below. An acceptance of a bankruptcy application begins a stay of actions against the debtor.

The bankruptcy administrator is a new concept in Chinese Law, and is appointed by a People's Court when it accepts a bankruptcy application. Creditors may apply to have the administrator replaced for failing to perform his or her duties, while the administrator may only resign with 'cause' and with the permission of the appointing People's Court. The administrator has broad powers to operate the debtor company during the pendency of bankruptcy proceedings, and other powers specified in the Bankruptcy Law. For example, the administrator may review a request by a creditor to set-off a debt owed by the creditor to the debtor (if incurred prior to the bankruptcy application acceptance date) against amounts owed by the debtor to the creditor.

An administrator may elect to have the company perform or rescind a contract that has not been fully performed as of the date the bankruptcy application was accepted. Note, however, that a contract is deemed rescinded if the administrator files to respond to the contract's counterparty within two months of the bankruptcy application acceptance date. Also, a contract is deemed rescinded if an administrator fails to provide security, if requested by the contract counterparty after the administrator informs such counterparty that the contract in question is to be performed. The administrator reports to the People's Court and the creditors committee.

The Bankruptcy Law sets forth new avoidance provisions:

a) Acts outside the ordinary course of business may be voidable if they occur within 1 year of the bankruptcy application acceptance date;

b) Payments made to creditors while the debtor is insolvent, within 6 months of the bankruptcy application acceptance date are voidable; and

c) Concealing or diverting the bankrupted company's assets to avoid liabilities is void. The administrator may recover any assets lost through a void or voidable act, and in certain circumstances, debtor's legal representative and other responsible personnel may have to indemnify the debtor for resulting losses.

More Options

Under the Bankruptcy Law, a debtor may be declared bankrupt, may apply for reorganization or may apply for conciliation.

Bankruptcy

If a debtor is declared bankrupt, all of its assets must be sold by auction, unless the creditor's meeting decides otherwise. Unlike the previous bankruptcy regime in China, the Bankruptcy Law provides that secured creditors have payment priority to the extent of the value of the secured property, with any shortfall classified as unsecured debt. After payment of secured debt, payment priority in a liquidation is:

a) Bankruptcy expenses;

b) Unpaid employee's salaries and social insurance premiums;

c) Outstanding tax liabilities; and

d) Unsecured debt. Note, however, that any employment-related claims that accrue prior to Aug. 27, 2006, the Bankruptcy Law's issuance date, rank higher than secured claims.

Reorganization

The Bankruptcy Law enables the debtor or creditor to apply to the People's Court for reorganization of the debtor, a new concept in Chinese law. If a creditor applies to bankrupt a debtor, either of the debtor or investors holding more than one-third of the debtor's registered capital may apply to reorganize the debtor. Generally, the administrator manages the entity in bankruptcy, although the debtor's management can petition the court to continue managing the debtor's operations.

Within 6 months of the start of the reorganization period, which period could be extended to nine months with court approval, the debtor or administrator must submit a reorganization plan, including plans for the repayment of debtor's debt and/or restructuring of its debt. Upon receiving the reorganization plan, the court is to convene a meeting of the debtor's creditors. At such meeting, creditors are divided into classes (secured, unsecured, etc.), and the reorganization plan must receive approval from a majority of the creditors in each class, representing at least two-thirds of the total confirmed claims in each such class. If approved, the plan is submitted to the court for approval before implementation.

Note that secured creditors are restricted from enforcing their secured rights during the reorganization period, and secured creditors may not vote on a reorganization plan that involves the sale of company assets until such secured creditors terminate their security interests.

Conciliation

Conciliation, similar to Chapter 11 in the U.S. Bankruptcy Code, is another new concept introduced by the Bankruptcy Law and allows a debtor to propose a settlement of its debts with its creditors. If the court accepts a debtor's conciliation offer, it will convene a meeting of the debtor's creditors. A conciliation settlement must be approved by a majority of the creditors attending such meeting, holding more than two-thirds of the total amount of conformed claims, except secured claims, against the debtor. If a conciliation settlement is rejected, the court must declare the debtor bankrupt.

Cross-Border Insolvency

While China has not adopted the United Nations Commission on International Trade Law Model Law on Cross-Border Insolvency (UNCITRAL), and that law's framework for cooperation in cross-border insolvency, the Bankruptcy Law does, for the first time, address cross-border insolvency issues. Article 5 of the Bankruptcy Law provides an avenue to affect Chinese bankruptcy procedures against debtor's assets located outside of China, provided that China is established as the 'center of main interests' of the debtor. It appears as through the United States and other jurisdictions that have adopted UNCITRAL would treat China, at least insofar as enforcement of Chinese bankruptcy procedures overseas, as if China had adopted UNCITRAL.

The Bankruptcy Law also provides that, in certain situations, a foreign bankruptcy proceeding may be binding within China as against the debtor's assets located in China. In order to be enforced in China, the foreign judgment must:

a) Be from a jurisdiction that has relevant treaties or reciprocal relations with China;

b) Not violate Chinese State sovereignty, national security or social public interest; or

c) Not harm the lawful rights of creditors inside China.

Management Liability

The Bankruptcy Law introduces to Chinese law management liability concepts found in other jurisdictions' bankruptcy codes. The debtor's directors and officers may be subject to civil liability if the debtor's bankruptcy is the result of a breach by the directors or officers of their duties of loyalty and diligence to the debtor. Directors and officers of a bankrupt enterprise are barred from assuming an officer or director position in another enterprise for a period of 3 years, starting on the date the bankruptcy concluded. A bankruptcy administrator may recover any of debtor's assets improperly taken by debtor's managers.

Conclusion

The Bankruptcy Law is a significant new step in China's legal development, and is an improvement over the previous bankruptcy regime in China. The Bankruptcy Law is the first, unified law on the subject in China, and brings China's bankruptcy system closer to international standards. The more streamlines rules in the Bankruptcy Law will improve the transparency and certainty of China's bankruptcy system. Still, challenges remain. Provincial courts might resist applying the new bankruptcy rules to important local enterprises. Future implementing regulations will flesh out ambiguous areas of the Bankruptcy Law, but this law is a significant step forward.

Michael E. Burke is an associate in the International Practice Group of Williams Mullen (www.williamsmullen.com). He is resident in the Firm's Washington, DC office. Since 2003, he has been a Visiting Fellow at the Asian Institute of International Financial law at Hong Kong University's Faculty of Law. He currently is a Co-Chair of the China Committee of the American Bar Association's Section of International Law.

After a long gestation China's new Enterprise Bankruptcy Law (Bankruptcy Law) will become effective on June 1, 2007. The Bankruptcy Law was adopted by the Standing Committee of the 10th National People's Congress on Aug. 27, 2006, and will significantly change how Chinese and foreign entities analyze bankruptcy issues. The old law, the State Enterprise Bankruptcy Law (Trial Implementation), issued in 1986, regulated the bankruptcy process only for State-Owned Enterprises (SOEs) and, by the mid-1990s was seen to be in serious need of amendment.

The Bankruptcy Law is the first standardized bankruptcy law in China, replaces the old law and myriad other regulations, and removes some of the administrative uncertainty that existed under the former sets of regulations. The Bankruptcy Law applies to all enterprises 'with legal person status,' including SOEs, private companies, limited liability companies, companies limited by shares, and foreign-invested enterprises (FIEs). Individuals and partnerships are not subject to the new Bankruptcy Law.

The scope of the Bankruptcy Law is limited in two circumstances:

a) Financial institutions whose bankruptcy could harm China's economy may have their bankruptcy directly administered by relevant Chinese government authorities; and

b) SOEs that announce their bankruptcy prior to June 1, 2007 may receive assistance in the bankruptcy process from the Chinese government and must pay employment-related claims before any secured or unsecured creditor, a continuation of policy bankruptcies.

Starting the Process

Under the Bankruptcy Law, either a debtor or a creditor can file a bankruptcy application with the relevant People's Court. A debtor may make an application if it is:

a) Cash-flow insolvent;

b) Balance-sheet insolvent; or

c) 'Obviously' insolvent. A creditor may make an application only if its debtor is cash-flow insolvent.

The People's Court must decide within 15 days of receipt whether to accept such application. Debtors may contest an application made against them, and either a creditor or debtor may contest the rejection of a bankruptcy application. If accepted, the People's Court is to:

a) Notify the debtor and all of its known creditors of such acceptance; and

b) Appoint a bankruptcy administrator, as discussed below. An acceptance of a bankruptcy application begins a stay of actions against the debtor.

The bankruptcy administrator is a new concept in Chinese Law, and is appointed by a People's Court when it accepts a bankruptcy application. Creditors may apply to have the administrator replaced for failing to perform his or her duties, while the administrator may only resign with 'cause' and with the permission of the appointing People's Court. The administrator has broad powers to operate the debtor company during the pendency of bankruptcy proceedings, and other powers specified in the Bankruptcy Law. For example, the administrator may review a request by a creditor to set-off a debt owed by the creditor to the debtor (if incurred prior to the bankruptcy application acceptance date) against amounts owed by the debtor to the creditor.

An administrator may elect to have the company perform or rescind a contract that has not been fully performed as of the date the bankruptcy application was accepted. Note, however, that a contract is deemed rescinded if the administrator files to respond to the contract's counterparty within two months of the bankruptcy application acceptance date. Also, a contract is deemed rescinded if an administrator fails to provide security, if requested by the contract counterparty after the administrator informs such counterparty that the contract in question is to be performed. The administrator reports to the People's Court and the creditors committee.

The Bankruptcy Law sets forth new avoidance provisions:

a) Acts outside the ordinary course of business may be voidable if they occur within 1 year of the bankruptcy application acceptance date;

b) Payments made to creditors while the debtor is insolvent, within 6 months of the bankruptcy application acceptance date are voidable; and

c) Concealing or diverting the bankrupted company's assets to avoid liabilities is void. The administrator may recover any assets lost through a void or voidable act, and in certain circumstances, debtor's legal representative and other responsible personnel may have to indemnify the debtor for resulting losses.

More Options

Under the Bankruptcy Law, a debtor may be declared bankrupt, may apply for reorganization or may apply for conciliation.

Bankruptcy

If a debtor is declared bankrupt, all of its assets must be sold by auction, unless the creditor's meeting decides otherwise. Unlike the previous bankruptcy regime in China, the Bankruptcy Law provides that secured creditors have payment priority to the extent of the value of the secured property, with any shortfall classified as unsecured debt. After payment of secured debt, payment priority in a liquidation is:

a) Bankruptcy expenses;

b) Unpaid employee's salaries and social insurance premiums;

c) Outstanding tax liabilities; and

d) Unsecured debt. Note, however, that any employment-related claims that accrue prior to Aug. 27, 2006, the Bankruptcy Law's issuance date, rank higher than secured claims.

Reorganization

The Bankruptcy Law enables the debtor or creditor to apply to the People's Court for reorganization of the debtor, a new concept in Chinese law. If a creditor applies to bankrupt a debtor, either of the debtor or investors holding more than one-third of the debtor's registered capital may apply to reorganize the debtor. Generally, the administrator manages the entity in bankruptcy, although the debtor's management can petition the court to continue managing the debtor's operations.

Within 6 months of the start of the reorganization period, which period could be extended to nine months with court approval, the debtor or administrator must submit a reorganization plan, including plans for the repayment of debtor's debt and/or restructuring of its debt. Upon receiving the reorganization plan, the court is to convene a meeting of the debtor's creditors. At such meeting, creditors are divided into classes (secured, unsecured, etc.), and the reorganization plan must receive approval from a majority of the creditors in each class, representing at least two-thirds of the total confirmed claims in each such class. If approved, the plan is submitted to the court for approval before implementation.

Note that secured creditors are restricted from enforcing their secured rights during the reorganization period, and secured creditors may not vote on a reorganization plan that involves the sale of company assets until such secured creditors terminate their security interests.

Conciliation

Conciliation, similar to Chapter 11 in the U.S. Bankruptcy Code, is another new concept introduced by the Bankruptcy Law and allows a debtor to propose a settlement of its debts with its creditors. If the court accepts a debtor's conciliation offer, it will convene a meeting of the debtor's creditors. A conciliation settlement must be approved by a majority of the creditors attending such meeting, holding more than two-thirds of the total amount of conformed claims, except secured claims, against the debtor. If a conciliation settlement is rejected, the court must declare the debtor bankrupt.

Cross-Border Insolvency

While China has not adopted the United Nations Commission on International Trade Law Model Law on Cross-Border Insolvency (UNCITRAL), and that law's framework for cooperation in cross-border insolvency, the Bankruptcy Law does, for the first time, address cross-border insolvency issues. Article 5 of the Bankruptcy Law provides an avenue to affect Chinese bankruptcy procedures against debtor's assets located outside of China, provided that China is established as the 'center of main interests' of the debtor. It appears as through the United States and other jurisdictions that have adopted UNCITRAL would treat China, at least insofar as enforcement of Chinese bankruptcy procedures overseas, as if China had adopted UNCITRAL.

The Bankruptcy Law also provides that, in certain situations, a foreign bankruptcy proceeding may be binding within China as against the debtor's assets located in China. In order to be enforced in China, the foreign judgment must:

a) Be from a jurisdiction that has relevant treaties or reciprocal relations with China;

b) Not violate Chinese State sovereignty, national security or social public interest; or

c) Not harm the lawful rights of creditors inside China.

Management Liability

The Bankruptcy Law introduces to Chinese law management liability concepts found in other jurisdictions' bankruptcy codes. The debtor's directors and officers may be subject to civil liability if the debtor's bankruptcy is the result of a breach by the directors or officers of their duties of loyalty and diligence to the debtor. Directors and officers of a bankrupt enterprise are barred from assuming an officer or director position in another enterprise for a period of 3 years, starting on the date the bankruptcy concluded. A bankruptcy administrator may recover any of debtor's assets improperly taken by debtor's managers.

Conclusion

The Bankruptcy Law is a significant new step in China's legal development, and is an improvement over the previous bankruptcy regime in China. The Bankruptcy Law is the first, unified law on the subject in China, and brings China's bankruptcy system closer to international standards. The more streamlines rules in the Bankruptcy Law will improve the transparency and certainty of China's bankruptcy system. Still, challenges remain. Provincial courts might resist applying the new bankruptcy rules to important local enterprises. Future implementing regulations will flesh out ambiguous areas of the Bankruptcy Law, but this law is a significant step forward.

Michael E. Burke is an associate in the International Practice Group of Williams Mullen (www.williamsmullen.com). He is resident in the Firm's Washington, DC office. Since 2003, he has been a Visiting Fellow at the Asian Institute of International Financial law at Hong Kong University's Faculty of Law. He currently is a Co-Chair of the China Committee of the American Bar Association's Section of International Law.