Spectre of bankruptcy comes to China

China's businessmen have always needed resilience, but now they must become accustomed to the spectre of bankruptcy. For China now has a bankruptcy code with teeth, and the country's courts are beginning to enforce it with rigour.

Bankruptcy legislation in China started right after Deng Xiaoping launched his pro-market reforms three decades ago. The Law on Enterprise Bankruptcy (Trial Implementation), the first of its kind, was enacted in 1986.

Its execution, however, was crippled by its very narrow scope for application, the absence of corresponding laws governing corporate restructuring, excessive government intervention, incompatibility with the policy-based bankruptcy procedure then in place, technical errors, and a general inability to make the code operational.

So, in 2006, a revised version of the law was enacted, marking an important milestone in China's efforts to build an effective legal system as it moves towards a market economy. Compared with the original bankruptcy code, the 2006 code is firmly rooted in the needs of a market economy.

First, it aims to ensure that obligations are fairly and regularly met when a debtor becomes financially insolvent. Thus, it seeks to protect the lawful rights of both creditors and debtors.

The legislation also imposed a deadline to abolish "policy-based bankruptcy" - the practice adopted by the State Council to liquidate loss-making state-owned enterprises and resettle laid-off employees. Unlike the Bankruptcy Law, the administrative procedure has a different hierarchy of liquidation priorities: what a bankrupt SOE owes to its employees and the resettlement charges must be covered first and foremost by its total assets, including the enterprise's collateral, in order to reduce dependence on local governmental budgets.

Yet this process leaves the rights of creditors undefended, eliciting widespread criticism. The new Enterprise Bankruptcy Law redefines its scope of application to preclude overlap with other laws like the Social Security Law and the Labour Law.

Indeed, resettlement of laid-off SOE employees, and other social implications of layoffs, should now be addressed primarily by government through the social safety net, rather than as part of the bankruptcy process.

The new code also introduces the concept of "administrative receivership," whereby lawyers, certified accountants, and other intermediaries act as managers of enterprises undergoing bankruptcy.

The procedure abolishes the Liquidation Team, a long-standing regime that many alleged was unjust, aggressive in administrative intervention, unprofessional and unaccountable.

In order for this part of the law to go ahead, the Supreme People's Court issued judicial interpretations that set out who can be designated a company receiver and the amount and type of compensation they can be paid. Up to now, some 2,520 agencies and 388 individuals have been included on the list of receivers.

Yet problems remain. For example, receivers are paid unreasonably poorly in cases of limited assets; furthermore, the random, indiscriminate appointment of receivers sometimes leaves cases over- or under-staffed. Consequently, the job of receiver, though it carries strict liabilities, is highly risky in terms of reward. If no viable solution is found, no agency or individual will be willing to serve as the receiver in ordinary bankruptcy cases.

Another important innovation is the adoption of restructuring procedures based on other countries' experiences. The possibility of restructuring balances the interests of stakeholders and uses legal protection to help potentially risky enterprises prevent or avoid bankruptcy if a bailout is worthwhile or possible.

But stricter and more reasonable standards should be established for courts' approval of restructuring plans. For example, if the required majority of shareholders adopts such a plan, the court should protect the rights of the minority of creditors who may have opposed it.

And if the liquidation rate for creditors' common claims is defined as no lower than that at the time the draft restructuring plan was submitted for approval, compensation must be considered in the event that payment is delayed.

Moreover, the Bankruptcy Law, the Company Law, and the Securities Law should be well coordinated and mutually reinforcing. How can an enterprise being restructured, say, find a way to issue securities for financing if it cannot meet conventional standards such as profitability and net asset value, as required by the Company Law and the Securities Law? The law must contain specific provisions regarding such matters in order to ensure successful listing of restructuring firms.

To prevent fraud, an acute problem in the past, the new law established a "right of rescission," whereby the receiver can ask courts to rescind any action by a debtor that involves fraud, evasion, or unfair liquidation in the prescribed period before a bankruptcy petition is accepted and assets recovered. The system now holds the key to fairness liquidation. Moreover, the Criminal Law of the People's Republic of China now includes bankruptcy fraud.

The successful implementation of China's revised Bankruptcy Law hinges on its effective enforcement and abandonment of the mindset and practices shaped under the old version, especially in the era of policy-based bankruptcy. Despite the difficulties that remain, China's bankruptcy legislation is increasingly adapted to the market economy; the trend is irreversible.

The author is Professor of Law at Renmin (Peoples) University of China and Director of its Bankruptcy Law Research Center.