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Since its first promulgation in 2006, the Enterprise Bankruptcy Law of People's Republic of China (the Bankruptcy Law) has been playing an increasingly important role in the business environment in China. To facilitate the implementation of the Bankruptcy Law and to guide courts of all levels to deal with bankruptcy cases in a more efficient way, the Supreme People's Court of China (SPC) issued two judicial interpretations and one meeting minutes. Companies in financial distress, creditors and potential investors now have a clearer understanding of the bankruptcy procedures.
Basic concepts of the Bankruptcy Law
There are three types of bankruptcy proceedings available under the Bankruptcy Law, ie, liquidation, reorganisation and conciliation. Among these proceedings, liquidation and reorganisation can be initiated by both the debtor and creditor, while conciliation can only be filed by the debtor itself.
These three proceedings share similar initiating requirements, among which two specific insolvency elements have to be met:
- the debtor is unable to pay a debt that has become due; and
- the debtor's assets are insufficient to cover its debts, or the debtor obviously lacks the ability to pay its debts.
In addition, a bankruptcy reorganisation proceeding can be initiated if a debtor will possibly lose the ability to pay its debts.
Venue and jurisdiction
The court sitting at the debtor's domicile has jurisdiction over the debtor's bankruptcy proceedings. Domicile usually means the debtor's legally registered location or the place where a debtor conducts its main businesses.
In terms of the level of the courts, local people's court (the lowest level) have jurisdiction over most of the bankruptcy cases, while intermediate courts (one level higher than the lowest courts ) have jurisdiction over high-profile and complex cases.
Once a bankruptcy proceeding is initiated, a bankruptcy administrator will be appointed to monitor the case proceeding, whose main tasks include preserving and allocating the assets, and dealing with actions associated with the debtor. The selection of bankruptcy administrator is usually done by the court that has jurisdiction to the case, through a lottery from the roster of qualified bankruptcy administrators, which is prepared by its corresponding intermediate court or provincial higher court (the higher court is one level higher than the intermediate court and lower than the SPC). For high-profile and complex cases, biddings are also used for selection of administrators.
An official acceptance of a bankruptcy case will trigger an automatic stay in the following four aspects:
- individual repayment to the creditors;
- asset preservation measures imposed by courts on the debtor;
- enforcement proceedings against the debtor; and
- ongoing litigation and arbitration proceedings, until the bankruptcy administrator takes over the assets.
Treatment of executory contracts
Executory contracts are contracts that are entered into prior to the initiation of a bankruptcy proceeding and have not yet been fully performed by both parties at the time of initiation. The bankruptcy administrator has the power to decide whether to continue to perform executory contracts or terminate them, and the decision has to be made within the first 60 days of the bankruptcy proceeding, otherwise, the executory contracts will be deemed terminated.
The rescission right of bankruptcy administrator
The administrator can petition the court to declare void any transaction that is made for the purposes of avoiding debts, dissipating assets or fabricating or admitting untrue debts.
Certain transactions are avoidable if they took place within a year prior to the initiation of a bankruptcy proceeding. These transactions include:
- gratuitous transfer of assets;
- transfer at an obviously unreasonable price;
- creation of security for an unsecured debt;
- advance payment of an undue debt; and
- waiver of a credit.
Payments to an individual creditor within six months prior to the initiation of a bankruptcy can also be avoided if the debtor met the bankruptcy test at the time of the payment unless such payment is beneficial to the debtor's assets as a whole.
Creditors' meeting and voting rules
The creditors' meeting is an essential institution in a bankruptcy process, as most of the major decisions in relation to the debtor's liquidation, reorganisation and conciliation are to be reached by the creditors at the creditors' meeting.
Specifically, matters to be submitted for the creditors' review and approval include, without limitation:
- lists of claims;
- work and performance of the bankruptcy administrator;
- remuneration of the bankruptcy administrator;
- continuation of the debtor's business;
- reorganisation plans;
- reconciliation plans;
- asset disposal plans; and
- asset distribution plans.
Voting rules at the creditors' meeting generally follow a double-threshold standard, simple majority in the number of creditors present at the meeting with voting power, plus simple majority in the value of claims held by approving creditors.
One exception to the above rule lies in approving reorganisation plans, where creditors are divided into different classes during the voting. Namely:
- secured creditors;
- employee creditors;
- tax creditors; and
- unsecured creditors.
In respect of each class, a reorganisation plan must be approved by a simple majority of the number of the creditors and these consenting creditors must represent two-thirds or more of the total amount of the creditors' rights.
Cramdown of a reorganisation plan
Cramdown of a reorganisation plan by the court is allowed under the Bankruptcy Law, provided that:
- the secured creditor class has approved the plan, or if not, their secured interests have not been materially impaired by the reorganisation plan and reasonable compensations will be given for delayed payments;
- employment-related creditors and tax creditors will be paid in full, or if not, the relevant class has approved the reorganisation plan;
- the proportion of repayment unsecured creditors entitled to will be no less than that if there were a liquidation proceeding at the time of approving the reorganisation plan, or the relevant class has approved the reorganisation plan;
- the adjustment on the equity holders' rights and interests is fair and equitable, or the equity holder class has approved the reorganisation plan;
- members within a same class are treated equally, and the liquidation order is in line with the statute; and
- the debtor's operation plan is feasible.
Enforcement of a reorganisation plan
After the reorganisation plan has been approved, the debtor will be responsible for its implementation, while the bankruptcy administrator will act as a supervisor. When the bankruptcy administrator believes that the reorganisation plan has been fully performed, it will submit a report to the court for the court's final decision on the completion of the reorganisation.
If, however, the debtor is no longer able to implement the reorganisation plan, the bankruptcy administrator or any interested party may petition the court to terminate the reorganisation plan. The debtor will then be liquidated.
Under the Bankruptcy Law, the priorities of different claims on the debtor's assets are determined in the following descending order:
- secured claims to the extent of the value of the security;
- administration expenses and debts incurred for the benefit of the assets as a whole (eg, debts incurred for performing executory contracts);
- employment-related claims;
- tax claims; and
- unsecured claims.
If the debtor's assets are insufficient to cover the administration expenses, the administrator will apply to the court to terminate the bankruptcy proceeding.
Major updates of 2018
The SPC Meeting Minutes
The most important update in the legal practices of bankruptcy law in recent years is the Notice of the Supreme People's Court on Issuing the Minutes of the National Court Work Conference on Bankruptcy Trials (the SPC Meeting Minutes), published on 4 March 2018. According to judges of the SPC, the SPC Meeting Minutes was issued to facilitate the supply-side structural reforms, get rid of the 'zombie companies', promote the high-quality development and disperse the market risks.
In general, the SPC Meeting Minutes contains eight sections and 50 articles. This article will address four major aspects:
- selection of bankruptcy administrators;
- detailed rules on reorganisation;
- substantive consolidation; and
- cross-border bankruptcy.
Selection of bankruptcy administrators
A bankruptcy administrator is the main facilitator and executor in bankruptcy cases, and thus their capabilities are crucial in the effective handling of bankruptcy cases. The SPC issued the Provisions on Designating the Administrator during the Trial of Enterprise Bankruptcy Case (the Administrator Designation Provisions) in 2007, soon after the Bankruptcy Law came into effect, to set out rules on how bankruptcy administrators should be selected and appointed in bankruptcy cases.
According to the Administrator Designation Provisions, higher courts at provincial level should prepare their roster of qualified bankruptcy administrators; and only institutions, including law firms, accounting firms and liquidation firms, that have offices or branches in that particular province are eligible for the roster. For normal bankruptcy cases, the bankruptcy administrator will be selected from the roster by lottery, and for more complex cases, courts sometimes may select the bankruptcy administrator through a bidding process.
With the increasingly frequent emergence of large-scale and complex bankruptcy cases in recent years, the SPC felt that the Administrator Designation Provisions no longer met the practical needs in selecting competent and appropriate bankruptcy administrators. Consequently, the SPC proposed three improvements in this SPC Meeting Minutes:
- encourage a competition mechanism to select bankruptcy administrators, especially in high-profile cases such as the bankruptcy of a listed company, to guarantee the competency of the selected administrator;
- expand the roster pool of certified bankruptcy administrators by introducing professionals in bankruptcy and enterprise management experts, and reaching out to external bankruptcy administrators from other provinces when needed; and
- facilitate the establishment of bankruptcy administrators associations and setting up administrators' compensation funds.
Further guidance on cramdown
The SPC Meeting Minutes requires courts to exercise extra caution when cramming down a reorganisation plan that is not approved by any voting class. Specifically, the SPC imposes two additional conditions for the use of cramdown:
- if there are multiple classes of creditors, at least one class has approved the reorganisation plan; and
- the dissenting votes in each class are entitled to no less then what they could have received had the debtor been liquidated.
Amendment of reorganisation plans
The SPC Meeting Minutes allows the debtor or the administrator to amend the approved reorganisation plan once, given the original plan becomes infeasible due to change of national policies, laws and regulations. Debtors or the bankruptcy administrators may petition to amend the reorganisation plan, and the amendment must go through the voting procedure again. If the proposed amendment is not approved, the court will convert the reorganisation proceeding into liquidation proceeding.
The Bankruptcy Law does not contain the concept of pre-packaged reorganisation, which allows the debtor and its major creditors, investors and other key stakeholders to formulate and agree on a reorganisation plan, and then have the court approve the agreed plan expeditiously. In practice, there have been pilot experiments of pre-packaged reorganisation in some provinces. For instance, debtors in Zhejiang Province can preregister with local courts before commencing formal bankruptcy proceedings, and thus relevant parties are able to start negotiations at a relatively early stage to prevent a further deterioration of the debtors' financial conditions.
The SPC also recognises the value and importance of pre-packaged reorganisation. The SPC Meeting Minutes encourages courts to explore different approaches to pre-packaged reorganisation and confirms that the reorganisation plans can be prepared by out-of-court agreements reached by the debtors, creditors and other stakeholders.
Substantive consolidation among affiliated debtor entities is a double-edged sword – on the one hand, it is helpful to prevent the debtor's fraudulent conducts and asset manipulations that jeopardise the creditors' interest, and on the other hand, the abuse or overuse of substantive consolidation may unfairly reduce the recovery rate of some creditors. In light of a number of controversial consolidation cases encountered by local courts, the SPC Meeting Minutes stresses that substantive consolidation should only be used in exceptional circumstance, and it also lays down strict criteria and remedial procedures.
Criteria for consolidation
As an exception to the general rule of respecting the company's independent legal personality, substantive consolidation can only be invoked when:
- the legal personality of each affiliate is highly mingled;
- the differentiation of each affiliate's assets is excessively costly; and
- the separation of bankruptcy proceedings will result in unfair treatment of the creditors.
Special procedures for consolidation
Upon the court's receiving of a petition for consolidation, it shall notify the interested parties and convene a hearing among them. It shall also make the consolidation decision taking into consideration a totality of factors, including, the extent and duration the affiliates' assets have been mingled, interparty debts and claims among the affiliates, impact of consolidation on the overall interests of creditors, and impact of consolidation on the likelihood of successful reorganisation.
Should any interested party oppose to the consolidation decision, it may petition the court of a higher level for a review of the consolidation decision.
The assets of the consolidated affiliates are deemed as one single estate, the debts and claims between the consolidated affiliates are extinguished, and creditors of the consolidated affiliates will participate and receive payments through one bankruptcy proceeding. In case of reorganisation, only one reorganisation plan will be made to cover all consolidated affiliates, and one affiliate remains after the reorganisation.
Article 5 as the basis for recognition and enforcement
Article 5 of the Bankruptcy Law provides the basis and criteria for recognising foreign bankruptcy proceedings. First, recognition must be based on treaty or reciprocity. Second, recognition cannot be contrary to the basic principles of Chinese laws, jeopardise China's sovereignty, security or public interest, or impair the legitimate rights and interests of domestic creditors.
To our knowledge, regardless of being effective for a decade, article 5 has never been invoked so far. This is mainly because:
- there are few, if any, treaties or conventions to which China is a signatory that provide for a basis for recognition of foreign bankruptcy proceedings; and
- Chinese courts have adopted a narrow theory of factual reciprocity, which means reciprocity cannot be established unless a Chinese bankruptcy proceeding has been actually recognised in the relevant foreign jurisdiction first.
Recent development on reciprocity
In the past two years, there has been a slight but discernable change of courts' attitude regarding the reciprocity. In Several Opinions of the Supreme People's Court on Providing Judicial Services and Safeguards for the Construction of the 'Belt and Road' by People's Courts (the 2015 SPC Opinion), the SPC opens the door for lower courts to adopt a more flexible theory of reciprocity, allowing Chinese courts to take the first step in recognising judgments of another jurisdiction after considering factors such as:
- past communications with the other jurisdiction on the intention to build international judicial cooperation; and
- its commitment of providing judicial reciprocal treatment.
Despite the more liberal reciprocity theory, questions remain as to:
- whether the 2015 SPC Opinion extends to foreign bankruptcy proceedings or merely applies to ordinary court judgments outside of bankruptcy scenario; and
- whether the opinion should be limited to cases or jurisdictions in relation to the Belt and Road Initiative, or reflects a broader change of position.
Aside from the development of the reciprocity theory, in 2015, the United States Bankruptcy Court for the District of New Jersey recognised a Chinese bankruptcy proceeding in relation to Zhejiang Topoint Photovoltaic Co, Ltd. After multiple hearings, Chief Justice Gloria M Burns issued an order approving the debtor's petitions of:
- the bankruptcy proceeding commenced in China to be recognised as a 'foreign main proceeding' under Chapter 15 of the Title 11 of the United States Code; and
- relevant judicial assistance to be taken in the United States, including the automatic stays, etc.
This precedent appears sufficient to fulfil even the strictest factual reciprocity requirement under Chinese law. Given the extensive trade and investment relationships between the United States and China, a US debtor may knock on the door of a Chinese court before long to seek recognition of US bankruptcy proceedings based on reciprocity.
Improvements in the SPC Meeting Minutes and the future outlook
The SPC Meeting Minutes has just two general provisions on cross-border bankruptcy. It stresses the importance of balancing different interests in cross-border cases and encourages lower courts to explore a 'new method' of applying reciprocity (which may be read to echo the 2015 SPC Opinion). It further states that, if recognition is granted pursuant to article 5, the foreign debtor's assets in China should first be used to pay off domestic priority creditors (ie, secured creditors, employment-related and tax creditors, etc) and the remaining assets can be distributed according to the rules of the foreign court. Recognising the urgent need for detailed rules on handling cross-border bankruptcy, the SPC is said to be working on further guidelines in respect of recognition of foreign bankruptcy proceedings.