A fresh wave of foreign capital, stuck for somewhere better to go, is preparing once again to flood the Chinese economy, with its new World Trade Organization (WTO) membership and gravity-defying 8% GDP growth rates. It is worth pausing to consider whether, if the advantages of WTO membership prove as illusory as the central government's pump-primed growth figures, this new wave of foreign capital will disappear down the gaping cracks of inefficiency still evident in China's economy or be allowed to flow into the more efficient areas. Of course, it may become necessary for it to retreat altogether.
Bankruptcy law and its modern cousin, reorganization law, are designed to permit the orderly reallocation of capital from inefficient businesses to more efficient ones. It is a lubricant that permits scarce capital to flow to those areas of an economy where it is going to be best used. It is suggested that a highly-developed bankruptcy law is more important to a developing economy, which faces rapid structural change, than to a developed one. Indeed, the International Monetary Fund (IMF) lists bankruptcy law reform as one of the most important ingredients for sustainable economic growth in post-crisis Asia. How then does China's bankruptcy law stack up?
There is no uniform bankruptcy code in China. Instead there is a patchwork of laws promulgated at various stages of China's economic development, supplemented from time to time by opinions from the Supreme People's Court. These laws apply various bankruptcy regimes depending on the nature of the legal entity in question.
However, the lines of demarcation are not always clearly drawn, which results in overlap and confusion.
The following are the most important laws and procedures applicable to bankruptcy proceedings in China:
the PRC Enterprise Bankruptcy Law (Trial Implementation), promulgated on December 2 1986;
the Opinion of the Supreme People's Court on Several Problems in the Implementation of the PRC Enterprise Bankruptcy Law, (Trial Implementation), issued on November 7 1991;
Chapter 19 of the PRC Civil Procedure Code, promulgated on April 9 1991; and
the opinion of the Supreme People's Court on Certain Questions Concerning the Applicability of the PRC Civil Procedure Code, issued on July 14 1992.
While the Civil Procedure Code (CPL) is of general application, the Enterprise Bankruptcy Law (EBL) only applies to the bankruptcy of state-owned enterprises. The EBL does not apply to foreign investment enterprises, such as Sino-foreign joint venture enterprises and wholly foreign-owned enterprises, and other forms of entities, such as limited liability companies, and joint stock limited companies. Nevertheless, given the rather limited scope of corporate bankruptcy provisions in the CPL, the EBL may be a source of reference for the Chinese courts when a bankruptcy petition is filed against a legal entity other than a state-owned enterprise.
The operation, closure, bankruptcy and liquidation of financial institutions and insurance companies is subject to the approval and supervision of the People's Bank of China and the China Insurance Regulatory Committee respectively. The Regulations on Close-down of Financial Institutions (Close-down Regulations) issued by the State Council on November 14 2001 are essentially designed to facilitate the restructuring or closure of the remaining 200 or so International Trust and Investment Corporations (ITICs). Under the Close-down Regulations, the regional government supervises the proceedings once the People's Bank approves a close-down. These proceedings are less than transparent and asset stripping by regional governments is widely suspected.
The Enterprise Bankruptcy Law
The EBL, adopted on December 2 1986, applies to state-owned enterprises.
Insolvency proceedings may be initiated by a state-owned enterprise in respect of itself (with the consent of its department in charge) or by its creditors.
A People's Court can declare an enterprise bankrupt where either (a) the enterprise suffers serious loss because of poor operations and management and is unable to pay its debts when due or (b) reorganization has been terminated and the enterprise is unable to pay its debts in accordance with the reconciliation agreement.
Once bankruptcy is declared, the enterprise is deprived of the possession and management of its properties and such functions are taken over by a court-appointed liquidation committee. All of its debts become due and payable.
The right of set-off by creditors of an insolvent enterprise is specifically recognized.
The Civil Procedure Code
The bankruptcy provisions in the CPL apply to "an enterprise with legal person status".
The process commences with either a creditor or the insolvent enterprise itself petitioning the court for a declaration of bankruptcy. A petition may be presented "if an enterprise or legal person suffers serious losses and is unable to repay debts when they are due".
Following the declaration of bankruptcy, creditors of the enterprise are notified and a public announcement made. Creditors must submit their claims within one month of receiving notification or within three months of the date of the public announcement if no notice is received. A committee is established by the court to gather in and realize the assets of the insolvent enterprise. Provision is also made for suspension of liquidation proceedings if a compromise is reached between the insolvent enterprise and its creditors.
In respect of the order of satisfaction of claims, the CPL provides that assets that constitute security-for-debt obligations should first be used to satisfy those obligations. The next claim on the insolvent enterprise's property is that of the costs of liquidation. Thereafter, assets are applied in the following order:
wages of staff and labour insurance fees;
taxes; and
other claims.
Where the property of the insolvent enterprise is insufficient to meet all claims within a single class, distribution is made on a pro rata basis within that class.
Cross-border recognition
In the context of its entry into the WTO, perhaps the most glaring shortcoming of the present Chinese bankruptcy law is that it is silent on the territorial reach of its own proceedings and, most importantly for foreign investors, the extent to which foreign bankruptcy proceedings will be recognized.
Jurisdiction over foreign assets
There is no express provision under Chinese bankruptcy law dealing with the question of whether a Chinese court, in a bankruptcy proceeding, has jurisdiction over assets or entities in foreign countries.
Although the EBL defines the bankrupt estate as including all assets and property rights under the management of the bankrupt company when bankruptcy is declared, it does not specify the territorial boundary of such assets.
The extent to which Chinese bankruptcy proceedings are recognized abroad will depend on the approach taken, that is whether it is universal or territorial, by the state in which recognition is sought. In view of the treatment given to foreign bankruptcy proceedings by Chinese courts (see below) and the vagaries of its own procedures, many could be forgiven for declining to recognize Chinese bankruptcy proceedings. However, in Hong Kong at least, it seems that proceedings under the EBL will be recognized. In a recent decision of the High Court of Hong Kong (deputy judge Gill, HCA156541/1999, July 31 2001) concerning garnishee proceedings brought by CCIC against dividends due to GITIC from the liquidation of GITIC (Hong Kong) (the author represents the liquidators of the latter), the GITIC bankruptcy proceedings under the EBL were recognized as a scheme for the universal collection and distribution of assets to all creditors, whether domestic or foreign, on a pari passu basis. There are no doubt more than a few foreign creditors of GITIC who were left bemused by this decision – which, incidentally, is under appeal. Nevertheless, this judgment may prove useful in convincing Chinese courts that they should reciprocate and recognize Hong Kong liquidators.
Recognition of foreign bankruptcies in China
Because Chinese bankruptcy law is also silent on this issue, the recognition of foreign bankruptcy or insolvency judgments and orders is dealt with under the general rules of the CPL with respect to the recognition and enforcement of foreign judgments.
While the CPL is loosely based on the Rome Convention notions of comity and reciprocity, in practice, unless a judgment happens to be from one of the few countries that has signed a bilateral judicial assistance treaty with China, the chances of the judgment being recognized, let alone enforced, by the Chinese courts are slim. Due to the territorial approach of the CPL and the parochial attitude of most Intermediate People's Courts, which appear to be particularly suspicious of foreign bankruptcy administrators, examples of foreign bankruptcy proceedings being formally recognized are almost unheard of.
That is not to say that foreign administrators, particularly Hong Kong liquidators, have not successfully recovered assets of insolvent companies in China. However, instead of having the power of the Chinese courts available to deal with recalcitrant debtors and former officers, they have had to use informal and, at times, extremely creative means to achieve a result for their creditors.
Shortcomings
The many shortcomings of the present bankruptcy laws can be distilled into the following points:
the multiplicity of laws causes confusion and uncertainty for creditors and debtors alike;
most laws were promulgated as short-term reactive measures to deal with the prevailing politico-economic climate at the time;
there is no empirical test of insolvency but rather vague and subjective notions of when an entity ought to be bankrupted;
fundamental gaps and weaknesses exist in the administration of bankruptcies – such as the management vacuum during the period from the bankruptcy order and formation of the Liquidation Committee for state-owned enterprises;
there is a lack of involvement of trained and experienced professionals in the courts, government and administration;
courts and liquidation committees are dominated by local and regional political interests;
there is inconsistent prioritizing of creditors' claims, particularly those of secured creditors;
the government has conflicting roles – as shareholder, creditor and administrator;
there is a lack of power and procedures to deal with antecedent transactions;
there is no reorganization culture;
there is a lack of recognition of foreign bankruptcy proceedings; and
not surprisingly, there is apathy on the part of creditors.
These problems present a serious impediment to the development of an efficient market economy in China and should be of concern to foreign investors.
Bankruptcy reform
Fortunately, many of these shortcomings were recognized by the central government as long ago as 1994 when it commissioned a review of bankruptcy law, which culminated in a new draft bankruptcy law being completed in 1995. Although the draft law has been improved over the past seven years, it appears no closer to being promulgated. While one might be forgiven for thinking that the whole process has been little more than window-dressing to appease the WTO, the greatest impediment seems to be the inability of the central government to find a solution (political and legal) to the massively inefficient and debt-laden state-owned enterprises – in particular the hundreds of regional banks and financial institutions (such as the ITICs) strewn across the country. The World Bank and others are presently working with the central government to find a solution to this problem and the People's Bank of China is in the process of closing down many of the ITICs (largely behind closed doors). However, a new broad-based bankruptcy law for China remains a long way off.
Nevertheless, it is worth noting the salient features of the 2002 Draft of the proposed new Bankruptcy Law:
It applies to partnerships and their partners, solely-invested enterprises (sole proprietorship) and their owners, foreign-invested enterprises, limited liability companies and companies limited by shares.
It does not apply to commercial banks, individuals and certain state-owned enterprises established before the 1994 Company Law.
The cash flow test is adopted as an objective test of insolvency.
Only the Intermediate Peoples' Court has jurisdiction over a bankruptcy case under the 2002 Draft.
Greater emphasis is put on reorganization, which is applicable to legal entities that are not able to pay their debts when due but may still be rescued (it is not clear what this means exactly).
The term of reorganization is six months, which may be extended to a maximum of 12 months.
The rights of the secured creditors are subject to an automatic stay during reorganization. There are also provisions regulating secured creditors' voting power at the creditors meeting in relation to the reorganization plan.
An independent administrator, being a lawyer, accountant or other qualified professional, must be appointed by the court on acceptance of a bankruptcy petition.
The administrator is responsible to the court and supervised by the creditors. They have broad powers, such as:
to take possession of all the books, contracts and corporate documents;
to investigate the financial status of the company;
to manage the assets of the debtor;
to convene a creditors' meeting;
to retain necessary employees;
to represent the debtor in court proceedings;
to draft the reorganization plan and get it approved; and
to implement the reorganization plan if appointed as the executive of such a plan.
The principle of universality is adopted subject to certain limitations:
bankruptcy proceedings under the 2002 Draft will apply to assets located abroad;
foreign bankruptcy/liquidation proceedings will be recognized provided there is a bilateral treaty and/or reciprocal arrangement and to do so is not contrary to the public interest or detrimental to Chinese creditors (that is there is plenty of room to manoeuvre).
Conclusion
While corporate memories may be short, they are not so short that they have already forgotten the clear lesson from both the Asian downturn and the technology bubble. Whatever the country and whatever the industry, fundamental economic principles cannot be ignored. One of those principles is the need for the free flow of capital, particularly in times of structural change and recession.
Due to the absence of a modern and comprehensive bankruptcy law, there is presently a flaw in China's development as a market economy. Without bankruptcy law reform and, in particular, better treatment of foreign investors, the predicted wave of foreign investment on the back of China's WTO entry may become a trickle, because foreign investors have already been bitten once.