Are the Bankruptcy Proceedings “SOE-Friendly”?

--History and New Developments in China

Gu MinkangSchool of Law

City University of Hong Konglwgu@cityu.edu.hk

Concept of Bankruptcy• Under the English law, a company cannot be made

bankrupt but may be wound up in case of insolvency. The terms “winding up” and “liquidation” may bear the same meaning, i.e., the process by which a company’s assets are collected, its debts are paid and the surplus, if any, are distributed among its members. These two terms, however, are different from the term “bankruptcy”. In Hong Kong, for example, the rules of bankruptcy are contained in the Bankruptcy Ordinance (Cap 6) whereas liquidations are governed by the Companies Ordinance.

Differences between Liquidation and Bankruptcy

• If comparing “liquidation” with “bankruptcy”, one could see one major difference, i.e., a company can be either solvent or insolventin a liquidation situation while in a bankruptcy situation, a debtor is insolvent. Today, if we just focus on the insolvent issue, bankruptcy of individuals and insolvency of companies would mean the same thing. In fact, these two terms have been used interchangeably.

History (1)

• China did not have a bankruptcy system until the later Qing Dynasty. During more than two thousand years before 1906, the Chinese society was dominated by a feudal legal tradition and ideology, i.e., “The debt of a father should be paid by his son (Fu Zhai Zi Huan)”. During that time period, a debtor did not have an equal status as a creditor.

History (2)

• The earliest Chinese Bankruptcy Law can be traced back to the Qing Dynasty. It was called “Pochan Lu” and enacted in 1906. However, the “Pochan Lu” was abolished in 1908 due to the protest from merchants. Later during 1915 to 1949, several Chinese bankruptcy laws were enacted by the Guomindang government. They are the basic structure of the nowadays’ Taiwanese Bankruptcy Law.

History (3) • On 2 December 1986, the first bankruptcy law, the Law

of the PRC on Enterprise Bankruptcy (the Bankruptcy Law) was promulgated by the 18th Session of the Standing Committee of the 6th National People’s Congress (the NPC). It was effective three months after the adoption of the Enterprise Law of the PRC on 1 November 1988. The Bankruptcy Law was promulgated on a trial basis and it contains only 43 articles, which indicated at the time of making this Law, Chinese legislators did not have any previous experience on the matter of bankruptcy and they intended that this legal document would be implemented on a trial basis.

Other Laws and Regulations (1)• On 9 April 1991, the Civil Procedure Law of PRC was

adopted and promulgated. Chapter 19 provides bankruptcy procedures for non State-owned enterprise legal persons. Presumably, some foreign invested enterprises are not within the coverage of the Chapter 19.Article 206 of the Civil Procedure Law states that the provisions of Chapter 19 shall not apply to following subjects, i.e., enterprises with no legal person status, individual industrial and commercial households, farming business households with contractual responsibility and individual partnerships. However, in line with relevant laws and regulations on foreign investment enterprises, some foreign investment enterprises are allowed not to take legal person status.

Other Laws and Regulations (2)• Supreme People’s Court (the SPC) issued the Opinions

Regarding Implementation of Bankruptcy Law of PRC on 7 November 1991. On 25 October 1994, the State Council issued the Notice Regarding Trial Implementation of SOEs in Several Cities. On 2 March 1997, the State Council issued the Supplementary Notice Concerning the Trial Implementation of SOEsBankruptcy, Merger and Reemployment of Staff and Workers (the 1997 Notice). On 18 July 2002, the SPC published the Several Issues on Hearing Enterprise Bankruptcy Cases (the Several Issues). The Several Issues are intended to clarify and streamline the bankruptcy proceedings on the one hand, the principles of protecting State-owned enterprises remains unchanged on the other hand.

Standards for a Bankruptcy• In order for an enterprise to be bankrupted, two

conditions must be satisfied. First, the enterprise is incurred significant losses due to inappropriate management. Secondly, the enterprise is unable to discharge matured liability.

• From these two conditions, one can feel that the legislative purpose is to save the SOEs rather than to get rid of them. Furthermore, it is not clear what is the standard of substantiate “significant”, nor is the standard to determine “inappropriate”.

Submission and Hearing of a Bankruptcy Application

• When a debtor is unable to discharge a matured liability, both creditor and debtor can apply for bankruptcy.

• However, before a debtor makes such an application, he shall seek an approval from a higher-level department in charge. In other words, even if a SOE suffers from a serious loss and is unable to pay matured debts, it may not be allowed to apply for bankruptcy proceedings if the higher-level department in charge disagrees. The high-level authorities might consider injecting new capital in order to rescue the SOE.

Court’s Jurisdiction

• A bankruptcy case will come within the jurisdiction of the local people’s court where the debtor is located. This indicates that a creditor cannot apply for a debtor to be declared bankruptcy in a local people’s court that has no jurisdiction over the debtor regardless how it is convenient to the creditor. (See new changes next)

New Changes• On the other hand, the Several Issues for the first time

address the issue of adjustment to the geographic jurisdiction, i.e., with the approval of the joint people’s court at a higher level, under a special circumstance, adjustment may be made to the geographic jurisdiction of a particular bankruptcy case within a province, autonomous region or municipality directly under the Central Government.This exception provides a legal basis for the parties in a bankruptcy case to assert “forum non conveniens”. Regrettably, the Several Issues fail to address what are those special circumstances.

Approval Process• When a people’s court receives an application, it

shall examine the application and decide whether to establish the case within 7 days. If the court does not satisfy the materials submitted, it should ask applicants to resubmit the additional materials within another 7 days. If an applicant fails to do so within the 7 days, the application will be treated as withdrawal.

• If the court decides not to establish the case, the applicants can appeal to a people’s court on a higher level within 10 days after the decision was received.

Scope of the creditor’s rights

• 12 rights.

Enterprise Supervision Committee

• The Several Issues establish an “enterprise supervision committee” for the first time. According to the provisions of Article 18 of the Several Issues, the members on the enterprise supervision committee should be formed by the competent higher authorities, representatives of the shareholders’meeting, management and major creditors of the enterprise.

Function of the ESC

• (1) to count and safe-keep the enterprise property; (2) to check creditor’s rights; (3) to carry out necessary business operation in the interest of the enterprise; (4) to pay for the necessary expenses approved by the people’s court; and (5) to do other work approved by the people’s court

• In respect of its functions, the enterprise supervision committee is much like the provisional liquidator in foreign jurisdictions.

Creditor’s Meeting

• A creditor’s meeting is a temporary organisation formed by all creditors. Because a creditor’s meeting is not a subject under Chinese Civil Law, it has no rights to engage in civil activities in its own name.

• However, during the meeting, only members of the creditor’s meeting whose claims are not secured will enjoy voting rights. This is because unsecured creditors are paid last out of the bankruptcy property. (see problem next)

Remaining problem• Article 13 of the Bankruptcy Law is understandable but

may cause a theoretical problem because this provision is seemingly contradicting to other statutory provisions. For example, Article 16(2) of the Bankruptcy Law states that the resolutions passed at a creditor’s meeting shall be binding on all creditors. Article 15(2) of the Bankruptcy states that a creditor’s meeting has the powers to discuss and adopt the draft conciliation agreement. According to these provisions, secured creditors have no voting power as to the draft conciliation agreement but have to be bound by the agreement. Can they effectively protect their own interests? The answer is negative. According to the Bankruptcy Law, the next step of the effectiveness of a conciliation agreement is probably a reorganisation for two years.

Conciliation and Reorganization (1)

• According to the CCH translation, “He Jie” is translated into “conciliation” while “Zheng Dun”is translated into “reorganisation”. Literally speaking, “conciliation” means that a negotiation between a debtor and creditors in order to discuss deferred schedule of payments, reduction of debts and reorganisation of debtor’s enterprise. Once an agreement could be reached, the debtor could avoid a situation of bankruptcy. This concept is quite similar to the concept of “reorganization” in the United States.

Conciliation and Reorganization (2)

• Contrary, the word “reorganization” in China refers to a special plan proposed by a higher-level department in charge of the debtor in order to facilitate the conciliation. In practice, a plan of reorganisation must be submitted to the people’s court and the creditor’s meeting.

Conciliation and Reorganization (3)

• According to the Bankruptcy Law, conciliation and reorganisation are two independent procedures. The conciliation is a part of bankrupt proceeding. It is within the bankrupt proceeding, but the conciliation itself could render the stay of the bankrupt proceeding. Until then, the debtor can start to do reorganisation. For this reason, reorganisation is not a part of bankrupt proceeding.

Conciliation and Reorganization (4)

• conciliation method is applied differently regarding SOEs and non-SOE enterprises. Where a SOE lodges a bankruptcy application, it is the higher level department in charge of the SOE, rather than the enterprise itself may, within three months of the hearing of the case in the people’s court, apply for reorganisation of the enterprise to be carried out.

Declaration of bankruptcy

• Three situations must happen in order for a people’s court to declare an enterprise bankruptcy. These three situations are listed by the Bankruptcy Law: (a) the situation of Article 3, (b) the situation of Article 21 and (iii) the situation of Article 22(2). Beginning with the date of declaration of bankruptcy, the enterprise should stop its production and operation.

Right to sue• One obvious breakthrough of the Several Issues

is the provision that the party is entitled to complain about the declaration of bankruptcy. Originally, Article 75 of the SPC’s Opinions on Issues concerning the Understanding and Enforcement of the Bankruptcy Law provides that, “The ruling of the people’s court in a bankruptcy case shall not be appealed except one to reject a petition for bankruptcy. A party who disagrees with the ruling may apply to the people’s court making the ruling for reconsideration”.

Liquidation Committee• The people’s court shall establish a liquidation

committee within 15 days of the enterprise being declared bankrupt to take over control of the bankrupt enterprise. One thing with Chinese characteristic is that the members of a liquidation committee are appointed by the people’s court. All candidates are from the higher-level department in charge of the enterprise, government financial departments, other relevant departments and professionals.(See problem next)

Remaining problem

• Even though the liquidators may be appointed from professionals, the existing situation is that only the accountants, auditors, economists and other economic type professionals are considered. Chinese lawyers play very little role in the bankruptcy proceedings.

Relation between LC and CC

• in order to speed up the bankruptcy proceeding, the Several Issues contain a remarkable provision, which says, “Where the liquidation committee’s property distribution plan is not adopted after deliberation twice at the creditors’meeting, the people’s court shall rule on it according to law. The advantage of this provision is the avoidance of unlimited delay of the liquidation committee’s property distribution plan at the creditors’ meeting.

The Bankruptcy Property• Theoretically speaking, the bankruptcy property must

contain three legal characteristics. • The first legal characteristic is that the bankruptcy

property must be the property legally owned by a debtor. • The second legal characteristic is that the bankruptcy

property must be disposable property. The mortgaged property is not a bankruptcy property.

• The third legal characteristic is that the bankruptcy property must be determined by a liquidation group. The last legal characteristic is that the bankruptcy property must be specified by the relevant laws and regulations.

Not bankruptcy property (1)• (The Several Issues) • other’s property possessed or used by the debtor based on a legal relationship such

as warehousing, safekeeping, processing, entrusted transaction, sales on a commission basis, borrowing, consignation or leasing;

• mortgaged property, property in lien and pledged property, except part of it on which the creditor has given up its preemptive right or residual part of it after preemptiverepayment of a secured creditor’s right;

• insured money, indemnity or compensation arising fro the destruction or loss of a guaranty;

• property with preemptive right according to law, except part of it on which the creditorhas given up its preemptive right or residual party of it after preemptive repayment of a specific creditor’s right;

• a specific thing which has not been transferred but for which a consideration has been fully provided, in a sale of a specific thing;

• property which has been delivered to the buyer but the procedure for a property certificate or registration of transfer of property has not been obtained the ownership in a sale of property with ownership retained;

• property of which the state exclusively has the non-transferable ownership; and• property owned by the trade union of the bankrupt enterprise.

Not bankruptcy property (2)

• In addition, the non-bankruptcy property also includes (a) the public welfare facilities such as the kindergarten, school and hospital of the debtor; and (b) housing sold to the bankrupt enterprise’s employee, in housing reform, for which a contract has been entered into and payment has been made.

Order of Distributing Bankruptcy Property (1)

• It is an international practice that the bankruptcy property will be used to pay the bankruptcy expenses first. As stated by the Bankruptcy Law, the necessary expenses includes following parts:

• Expenses incurred in the supervision, selling and distribution of the bankruptcy property;

• Expenses for the hiring of work personnel; • Expenses for the bankruptcy proceedings; • Other expenses paid out during bankruptcy

proceedings for the common benefit of creditors.

Order of Distributing Bankruptcy Property (2)

• After paying the bankruptcy expenses, the bankruptcy property will be distributed in the following order.

• Wages owed to employees by the bankrupt enterprise and fees for labour insurance;

• Taxes owed by the bankrupt enterprise; and • Bankruptcy claims.• (See problem next)

Remain Problem• The existing question is whether the wages of

employees should be paid from the bankruptcy property. Following the establishment of jobless insurance funds and other special funds, employees of bankruptcy enterprises will be able to get compensations from those funds. Taking Guangzhou as one example, the employees of a bankruptcy enterprise will be able to get economic compensations from the government and minimum payment is Rmb 800 yuan per month. Before an enterprise is declared bankrupt, the enterprise has already paid those funds as required by relevant laws and regulations.

Experience of Hong Kong• The future Chinese Bankruptcy Law should learn some

good experiences from other jurisdiction in order to improve the application of bankruptcy property. In Hong Kong, since 1985, the employees of bankruptcy enterprises may have received their wages and salaries from the fund established by the Protection of Wages Insolvency Fund Ordinance (Cap 380). Since 1991, the employees of bankruptcy enterprises may have received economic compensation from the Employees Compensation Assistance Fund established under the Employees Compensation Assistance Ordinance (Cap 365).

Protection for Employees of Bankrupt Enterprise

• the right to claim compensation enjoyed by the labourers against the enterprise which goes bankrupt and therefore cancels labour contracts is included in Article 37(2)(a) of the Bankruptcy Law;

• the labour remuneration for an informal employee owed by the debtor is included in Article 37(2)(a) of the Bankruptcy Law;

• the fund raised from the enterprise employees owed by the debtor is included in Article 37(2)(a) of the Bankruptcy Law;

• the living and medical treatment expenses of employees during liquidation may be paid in priority from the bankruptcy property.

Fraudulent Conveyance (1)• Chinese legislators have noticed these fraudulent

conducts and provided in the Bankruptcy Law that the following actions will be invalid if carried out by bankrupt enterprise 6 months before hearing and during the bankruptcy proceeding:

• Concealment, private distribution or gratuitous assignment of property;

• Irregular underselling of property;• Supply of property security to creditors originally without

property security;• Advance discharge of non-matured liabilities; and • Giving up its claims against others.

Fraudulent Conveyance (2)• Furthermore, according to Article 40 of the Bankruptcy

Law, if a bankrupt enterprise has carried out one of the fraudulent conducts and the conduct is discovered within a year of the conclusion of bankruptcy proceedings, the Court will recover the property and a further discharge of liabilities will be carried out. Within 18 months (6 month before the bankruptcy and 12 months after the bankruptcy), it is possible to discover the fraudulent conduct. As mentioned before, if a fraudulent conduct is discovered before or after 18 months, the court will not open the case again.

Administrative Sanction or Criminal Punishment Against Relevant Persons

• Usually the punishments will be in the form of administrative sanctions. Only in a rare situation where the legal representative of a bankrupt enterprise or the leaders of the higher-level department in charge of the said enterprise cause, through neglect of their duties, the bankruptcy of an enterprise which results in serious losses to State property, will criminal liability be investigated.

• (See problem next)

Remain problem• However, the Bankruptcy Law fails to provide civil liability.• On the other hand, the enforcement of the laws and

regulations is also a problem. For example, the Chinese Company Law of 1993 provides that a person shall not hold the position of company director, supervisor or manager if a period of less than three years has elapsed since a company or enterprise of which the person was a director, factory head or manager was held personally responsible for its bankruptcy, or which was declared bankrupt or dissolved as a result of unsound business operations.

Liquidation of FIEs• As mentioned before, the liquidation of FIEs is governed

by the 1996 FIEs Liquidation Measures (the Measures). A FIE can be liquidated either voluntarily or compulsorily. A voluntary liquidation refers to a situation that a FIE is able to form a liquidation committee to liquidate the enterprise. The liquidation committee will follow the provisions regarding ‘a regular liquidation’. On the other hand, a compulsory liquidation refers to a situation that a FIE cannot form a liquidation committee to liquidate the enterprise or there is a serious obstacle to implement the regular liquidation. The board of directors, the joint managerial institution, investors or creditors of the enterprise can apply to the approval institution of the enterprise for a special liquidation.

Amendment of China’s Enterprise Bankruptcy Law

• The New Bankruptcy Law has been for the first time examined by the 10th meeting of Tenth NPCSC last year. It is intended to replace the existing Bankruptcy Law. The New Bankruptcy Law draws upon western insolvency ideas and seeks to supply these to the particular Chinese experience by an attempt to synchronise the Chinese economy with international standard of commerce and bankruptcy.

Change One

• The scope of application has been significantly expended. It covers four types of subjects, i.e., enterprise legal persons; partnership enterprises and partners; sole proprietorships and their capital contributors; other economic entities, which are legally established and operated for profits.

Change Two

• The reorganization system has been established and emphasized. The New Bankruptcy Law has taken into account heavily the foreign experience and provides in detail the eligibility of reorganization, the process of application and examination, the reorganization plan’s making and enforcement.

Change Three

• The Sanction of fraudulent activities. The New Bankruptcy Law addresses various fraudulent activities such as hiding or illegally distributing assets, providing falsified debts or untrue debts, or directors embezzle property of bankrupt enterprises.

Change Four

• The special persons who are in charge of managing bankruptcy have been created. It is intended to preclude local governmental officials from participate in liquidation and to avoid local protectionism.

Policy based bankruptcy

• According to news, currently, about 3000 SOEs have been bankrupted in line with special policies, thus many difficult SOEswill be out of markets. So far, there will be 2000 SOEs need to be bankrupted based on special policies. After them, policy based bankruptcy will no longer exist in China.

Bankruptcy of natural person

• During the drafting process, some suggest to include in 23 million individual household businessmen and individual natural persons once they fail to pay for commodities. However, it is recognized that individual property registration system and social credit environment have not been well established. For this reason, this suggestion has not been accepted.

Will the Bankruptcy Law Become an “Umbrella” of Debt Escape?

• Since 1994, the phenomenon of “false bankruptcy and true debt escape (Jia Po Chan, Zhen Tao Zhai)” has become more and more popular. Some enterprises transferred properties or even privately disposed properties before applying for bankruptcy. In order to do so, one can divide an enterprise into two enterprises and then transfers all capital into the new enterprise. All debts will be bore by the old enterprise and then the old enterprise will apply for a bankruptcy. One can also keep the good parts of the enterprise in order to implement so-called “separate bankruptcy”.

Conclusion (1) • The bankruptcy law in China started with the

reform of SOEs. Because the bankruptcy of SOEs will affect the employment of workers, banks’ financial situation and eventually, the stability of the society, the bankruptcy of SOEsare subject to the administrative involvement. In this situation, the existing Bankruptcy Law becomes an instrument of making bankruptcy announcement. On a certain level, the involvement of administration in the bankrupt proceedings has damaged the prestige of the people’s courts.

Conclusion (2)• The existing Bankruptcy Law has been

promulgated for more than 10 years and cannot fit in today’s situation. Because, the existing Bankruptcy Law was implemented on a trial basis, it is understandable that it will contain some problems. For examples, the standard of bankruptcy, the payment order and the protection of secured creditors. Furthermore, due to the historical reasons, many important issues have not been thought or studied. For examples, bankruptcy of individuals and cross-border bankruptcy are two ignored topics.

Conclusion (3)• It is great to know that the New Bankruptcy Law has

been processing. The new draft was very close to the international practice and met the new situation of Chinese market economy. The new draft has a broad scope of application. It has detailed provisions regarding simple bankruptcy proceeding, protection of creditor’s interests, the system of bankruptcy manager, reorganisation mechanism and special proceeding for bankruptcy of SOEs. Furthermore, it was believed that the new draft contains provisions that are more creative and are easily operated.

Conclusion (4)• Even if China promulgates a New Bankruptcy

Law, it is important to ensure that China should not adopt a double standard in handling the different size enterprises, especially the different SOEs. As reported, the shutdown of big size enterprises such as Hainan Development Bank, Zhongchuang Industry and Guangxi Group were not done in accordance with the existing Bankruptcy Law. Furthermore, it is important to note that some debtors have treated the bankruptcy law as their umbrella when they tried to escape the debts owed.

Conclusion (5)

• Finally, it is hoped that China should adopt unified bankruptcy law in order to effectively deal with the bankruptcy of individuals, legal persons or non-legal persons; or bankruptcy of domestic enterprises and foreign invested enterprises. Ii is also necessary because both the market economy and the globalisation of world economy will demand the participation of various subjects with equal foot and national treatment.