Latest China bankruptcy law enhances creditor rights

ChinaÆs new bankruptcy law is an improvement in terms of general direction, but is unlikely to solve quickly the countryÆs longstanding problems, experts said at a gathering in Hong Kong this week.

ChinaÆs first enterprise bankruptcy law was established in 1986, but itÆs only with the latest revision, signed in August 2006 by president Hu Jintao, that employee protection has been subordinated to secured creditors.

These will now be refunded to the value of the collateral. Any deficiency will be treated as an unsecured claim.

Unsecured claims will be met after post-bankruptcy administrative costs and expenses; auxiliary worker benefits such as personal injury liabilities; and workersÆ compensation such as salaries and insurance.

Another innovation is that of the creditor committee, which will be able to impose joint pressure on the company after drawing up a rescue plan. If the debtor company does not agree with the plan after nine months, the creditor committee can force the company to liquidate. The creditor committee will also oversee the administrator if the latter engages in the disposal of assets. The committee may also ask the court to remove the administrator.

The law also includes remedies against fraudulent conveyancing. As a company faces bankruptcy, it often happens that assets are transferred to other parties in order to avoid repossession by the creditors. The possibility that this may happen, and the authority of the administrator to block such moves, has been formalized in the law.

The lack of fully developed bankruptcy proceedings, whereby a company is given the chance to restructure under temporary protection from its creditors, means that companies facing difficulties in China have traditionally stopped functioning in any practical sense, or were liquidated.

Both eventualities are regarded as being economically wasteful. Bankruptcy specialists stress that sometimes basically sound businesses may need to go through a bankruptcy process to clean up their balance sheets. That is currently lacking in China, meaning that businesses with decent fundamentals may go down unnecessarily. Even if liquidation does occur, in the past, creditors were far back in the queue, since the needs of the employees came first.

Although some observers were cynical about the new legislation, others believe it represents a significant improvement on what went before. ôWhile there are plenty of details that still need to be worked out, the fact that the Chinese leadership has pushed through this kind of creditor-friendly legislation through during a time of backlash against unchecked economic growth speaks volumes,ö says Stephen Scott, managing director with Alvarez & Marsal Asia.

In fact, the law does reflect one significant change. ôThis is the first time that Chinese firms, Sino-foreign joint ventures and wholly-owned foreign firms have been put on exactly the same legal plane with each other. Domestically, the law makes no distinction between state-owned enterprises and privately-owned enterprises,ö says Helena Huang, a partner at Kirkland and Ellis in New York.

The previous bankruptcy law only applied to state-owned enterprises. This aside, the law does not solve many practical difficulties. One of the biggest differences to the US is that US bankruptcies are supervised by a bankruptcy court, which has the authority to carry out far-reaching changes to the enterprise going through bankruptcy.

Bankruptcy courts have been at the forefront of some of the most cutting-edge legal and financial cases in the US.

In China, an administrator is appointed by an ordinary court. The court will very likely lack the specialized skills to understand the turnaround process. In addition, itÆs not clear what entity can act as an administrator. For state-owned companies, itÆs possible that the State Asset Supervision and Administration Committee (SASAC), or the asset management companies set up to handle bad debt in the banking system, will take on the function.

Even when the administrator is appointed if foreign law and accounting companies will be eligible to work on the turnaround. These might be the preferred choice of sino-foreign joint ventures. Observers say that despite the weaknesses of the law, it has significantly improved the potential for more sophisticated investments in China. ôIt used to be the case that investors would only invest in asset-backed distressed debt û essentially a real estate play. The new law, however, increases the universe of investors who would be willing to buy distressed debt,ö says James Dubow, also a managing director of Alvarez & Marsal Asia.

Nevertheless, the basic problem remains: the lack of clear authority on the part of the supervisor means that investors will still need to navigate the through conflicting government agencies. ôIn many cases, itÆs still not clear who has the final say in reaching an agreement. The new legislation does not solve that problem,ö says one observer, who preferred not to be named.