China’s new Enterprise Bankruptcy Law – a big step forward

07 September 2007

Luke Ryan, Darren FitzGerald

China’s new Enterprise Bankruptcy Law (the “New Law”) came into effect on 1 June 2007. It replaces the former Enterprise Bankruptcy Law which had been in place since 1986 (the “1986 Law”). The New Law applies to all legal enterprises including state-owned enterprises (“SOEs”).

The New Law is comprehensive and brings China’s insolvency law closer to standard international practices. This article summarises some of the key provisions.

Grounds for insolvency

Article 2 of the New Law sets out the grounds where the provisions of the New Law will apply. These are where a debtor:


  1. is unable to settle due debts;

  2. has assets which are insufficient to settle all due debts; or

  3. is “clearly insolvent”.

Whilst this is an improvement on the 1986 Law which did not set out the grounds of insolvency, some uncertainty still exists, particularly in relation to what “clearly insolvent” means in practice.

Role of the Court

Under the New Law, an application by a creditor to bankrupt a debtor will be made directly to the People’s Court. Previously, approval from the relevant Government department was required before bankruptcy proceedings could be issued.

Independent administrator

The New Law provides for the appointment of an independent administrator to manage the debtor’s assets during bankruptcy. An administrator can be a law firm, accountancy firm or a relevant government official. It is unclear if foreign firms will be able to act as administrators, although this seems unlikely.

The administrator:


  1. is appointed by the People’s Court;

  2. is subject to the supervision of a creditors’ committee; and

  3. has an obligation to report to the creditors’ committee.

This represents a significant development in the administration of insolvent companies as it adds transparency to the management and, in turn, should help protect creditors’ interests.

The Supreme People’s Court has released two ‘Provisions’ which further clarify the procedures for the appointment of administrators and their remuneration. These Provisions also came into effect as of 1 June 2007.

Management

The New Law provides for two alternative systems of administration. There is provision for the debtor to remain in possession of its business and assets during the implementation of a restructuring plan (subject to the supervision of the administrator). This is similar to the ‘Chapter 11’ system employed in the United States. Alternatively, the administrator can manage the restructuring directly, similar to the external administration regime used in the United Kingdom. It is not yet known how the People’s Court will choose between the different regimes or what the applicable criteria will be.

Priority of payment

The 1986 Law gave employees priority over all other creditors including secured creditors. This has now changed and Article 109 of the New Law provides that claims over specific, secured property will be repaid from such secured property. If the value of the secured property is insufficient to repay a secured creditor, they can claim for the balance as an ordinary, unsecured creditor. It is important to note, however, that Article 132 of the New Law states that employee entitlements (including wages and other benefits - such as pension contributions) incurred prior to 27 August 2006, are still to be paid from secured assets in priority to secured creditors’ claims. Financiers should be aware of this provision as such claims may reduce the value of any security.

Subject to the above, the order of priority for payment of creditors will be:


  1. bankruptcy fees and joint interest debts;

  2. unpaid wages, medical pensions, disabled pensions and compensation expenses;

  3. social security expenses other than those in 2. above and unpaid taxes; and

  4. ordinary bankruptcy claims.
Preferential prior transactions

Article 33 of the New Law provides that any debtor transactions made in the year prior to the bankruptcy which were undervalued or otherwise preferential, can be revoked by the People’s Court.

Conclusion

The New Law is a significant step forward for China and the regulation of its modern-day market economy. There are outstanding issues which will need to be addressed but it is certainly a positive development as it will bring greater certainty to creditors and third parties when dealing with insolvent companies both in terms of their position and the remedies available to them.