Understanding the New Enterprise Bankruptcy Law

By Zheng Zhibin and Zhang Ting*

The Enterprise Bankruptcy Law of People's Republic of China ("New Law") was finally adopted on August 27, 2006，after twelve years of drafting and deliberation. With a wider coverage and more complete structure than the old Bankruptcy Law,the New Law achieves many breakthroughs in legislative concepts and the regulatory system. The New Law integrates the scope of application, addresses the issue of cross-border bankruptcy, introduces the reorganization system and the administrator, and creates special regulations for bankruptcies of financial institutions. Also, the New Law provides creative solutions to the conflict between the rights and interests of employees and secured creditors by re-defining the repayment order of a bankruptcy estate. Additionally, it regulates misconducts during bankruptcy and imposes responsibilities on senior managers for corporate bankruptcy. The New Law made historical progress by filling the legislative vacuum of business exit and reorganization in China's market economy.

I. Extended Scope of Application of the New Law

The scope of application of the New Law is extended to all "enterprise legal persons," including state-owned enterprises (SOEs), private enterprises with a legal entity, Sino-foreign joint ventures, Sino-foreign cooperative enterprises, wholly-owned foreign owned entities and financial institutions. To provide a legal basis for the bankruptcy of non-legal person enterprises and non-profit organizations, the New Law provides that the liquidation of non-legal person organizations prescribed by other laws will now apply the New Law, if the liquidation falls within the scope of bankruptcy. Also, the policy to wind-up SOEs will come to an end; SOE bankruptcy will become a market procedure rather than an administrative action. However, "Any special matters regarding the bankruptcy of SOEs within the term and scope specified by the State Council shall be handled according to the requirements of the State Council before this Law comes into force."

II. Diverse Means of Initiating Bankruptcy

• Bankruptcy Initiated by the Debtor

Under the New Law, when the circumstances of bankruptcy are satisfied, the debtor may directly file a petition with the court for reorganization, conciliation or liquidation This is the first right granted to the debtor by law. After the court accepts a petition for bankruptcy and before it approves the debtor bankrupt, the debtor may file another petition for reorganization or settlement, which is the second right granted to the debtor by law.

• Bankruptcy Initiated by the Creditors

According to the New Law, the creditors may directly petition for reorganization or liquidation, but not for settlement. Also, the creditors are not allowed to initiate reorganization once the bankruptcy proceeding commences. The conditions for the creditors to initiate bankruptcy differ from that for the debtor which is only limited to cases where "the debtor fails to pay off its due debts." Neither the existing law nor the New Law imposes restrictions on the qualification of the creditors to initiate bankruptcy or reorganization. It appears that any creditor may petition for reorganization, regardless of the amount of creditor's rights that it holds, which is unreasonable.

• Reorganization Initiated by the Equity Holder

The equity holder can neither initiate liquidation or conciliation, nor petition for reorganization directly. If a creditor files a petition for reorganization against a debtor and the court accepts the petition, then, at that time, the equity holder may petition for reorganization before the court orders the debtor bankrupt. That is the only time the equity holder may petition for reorganization. Also, only equity holders whose capital contribution is greater than 10% of the debtor's registered capital are qualified to petition.

• Bankruptcy Initiated by the Party Liable for Liquidator

The New Law provides that "where an enterprise legal person has been dissolved but has not been liquidated or has not completed liquidation and the assets are not sufficient to pay off its debts, the party liable for liquidation shall petition for bankruptcy with the court."Therefore, it is both the legitimate right and legal duty of the party liable for liquidation to initiate bankruptcy. Such party may only petition for bankruptcy, not reorganization or settlement. However, the New Law is silent on the penalties for failure to initiate bankruptcy.

• Initiating Bankruptcy of Financial Institutions

According to the New Law, financial institutions may only initiate reorganization or bankruptcy.They may not petition for conciliation.Distinguishing a financial institution's bankruptcy from bankruptcies by other entities is the ability of competent financial regulatory authorities to initiate bankruptcy.

III. Important Time Limits During Bankruptcy

The New Law specifies important time limits to promote the timeliness of the acceptance, hearing and other procedures, as well as to encourage parties to exercise their rights within the corresponding time limits. The important time limits specified include:

(1) time limits regarding the court's acceptance of the petition (including the time limit for the court to notify the debtor, for the debtor to respond with opposition, for the court to rule whether to accept the petition, for the delivery of the court's acceptance ruling and the court's notification and announcement, for the delivery of the court's non-acceptance ruling and rejection of petition, and for appeal);

(2) time limits regarding actions after the court accepts the bankruptcy petition (including the time limit for declaring the creditors' rights, for the administrator to rescind contracts to be performed, for convening the first creditors' meeting, for the administrator to notify the creditors, for exercising the right of revocation, for the delivery, notification and announcement of bankruptcy ruling, and for collecting the distribution of the bankruptcy assets);

(3) time limits during reorganization (including the time limit for proposing, voting on, and approving the reorganization plan and for convening the creditors' meeting); and

(4) time limits regarding the completion of bankruptcy (including registration write-offs, annulling the entitlement to bankruptcy assets distribution, and recourse for assets upon the completion of bankruptcy).

IV. Introduction of the Administrator

The New Law introduces the administrator system, which manages the bankruptcy of an enterprise in a mechanism that better satisfies the interests of the parties. According to the New Law, the court designates the administrator, and the creditors' meeting is empowered to petition to replace the administrator. The administrator is designated at the beginning of the bankruptcy proceeding in China.The New Law provides that the liquidator and professional service providers (such as law firms, accounting firms, and liquidation firms) may serve as the administrator. Additionally, the court may designate an individual with competent professional knowledge and qualifications as the administrator. When an individual serves as an administrator, that individual is required to purchase professional liability insurance.Administrators are entitled to remuneration for their service. The court decides the amount of remuneration, and the Supreme People's Court delineates specific provisions to calculate the remuneration. The creditors' meeting has a right to examine the expenses and the remuneration of the administrator and make inquiries regarding the remuneration. The remuneration to the administrator is included in bankruptcy expenses and paid out of the debtor's property.

V. Declaration and Confirmation of Bankruptcy Claims

According to the New Law, creditors must declare the claims they hold when the court accepts the petition for bankruptcy, whether or not such rights are secured or unsecured, mature or immature, confirmed or unconfirmed, conditional or unconditional, with or without time limit, definitive or to be settled. However, employee's claims, such as wages, insurance premiums, and compensation do not need to be declared. In addition, the New Law provides a special provision regarding the declaration of the creditors' rights for creditors with joint and several liability. The creditors must declare their claims within the time limit for declaration. The creditors risk nonpayment of claims if they delay their declaration. The New Law expressly provides that "the creditors may make supplementary declarations before the final distribution of the bankruptcy estate. However, the said declaration does not apply to the bankruptcy estate distributed before the declaration is made. The costs for examining and confirming the supplementary declaration shall be borne by the creditors who make such declaration."The creditors must declare their claims to the administrator, who records the claim into a book, examines the declared creditor's rights, formulates a claim sheet, and submits the form to the first creditors' meeting for verification. If the debtors and creditors agree with the claim sheet, then the court rules on the claims. If any debtor or creditor disagrees with the claim sheet, then the disagreeing party may initiate an action with the court that has accepted the bankruptcy case.

VI. Secured Rights and Interests during Bankruptcy

The New Law clearly defines bankruptcy claims as the claims creditors hold against a debtor at the time the court accepts the petition for bankruptcy. Since no restrictions or exceptions apply to this definition, bankruptcy claims defined by the New Law include secured claims. The New Law also provides that after the court accepts the petition for bankruptcy, the repayment of debts made by a debtor to each respective creditor is invalid. The debtor may not repay the creditors, including secured creditors. However, the New Law does provide priority to secured claims in particular assets for repayment from those assets. Restricting the exercise of secured claims would be against the legislative intent of establishing secured claims, since the rights of secured creditors might be impaired, the secured assets might be devalued because of changes of market situation, depreciated due to further use, or damaged due to accident. As a result, remedies are available to secured creditors, including allowing secured creditors to file a petition to defreeze a frozen bankruptcy asset. The New Law states "in the case of possible damage or significant loss of value, which may harm the rights of secured creditors, the secured creditors may file petition with the court to resume the exercise of the secured creditors' right."However, these remedies for secured creditors are only available during reorganization. The New Law adopts an approach based on certain time limits for the repayment order of secured claims and employees' claims. Specifically, the priority of repayment is different before and after the promulgation date of the New Law ("the Date"). The employee's claims established before the Date have priority over secured claims. Where the unsecured assets of the bankrupt entity are insufficient to repay the employee's salaries, the insufficient amount shall be repaid from secured claims. Secured claims established after the Date enjoy priority over the employees' claims and other welfare, which can only be paid from unsecured assets. However, it should be noted that in the event that the employees' claims established after the Date can not be fully repaid by unsecured assets, the interests of employees may come in conflict with that of secured creditors, which is likely to cause social disruptions.

VII. Balancing the Rights and Interests

• Relationship between the court and the administrator

Generally, the court is the supervisor of the administrator, who is appointed by the court and whose responsibilities and pay are decided by the court. The administrator reports to the court and acts with the court's approval in many cases, including (1) employing necessary personnel; (2) resigning as administrator; (3) continuing or terminating the operation of the debtor, (4) performing any of the acts provided in Article 69of the New Law before the first creditors' meeting; and (5) performing any of the acts provided in Article 69 of the New Law, in absence of the creditors' committee.

• Relationship between the court and the self-governing creditors' meeting and committee

The New Law values the self-government of the creditors and establishes two self-governing creditors' organizations, which are the creditors' meeting and the creditors' committee. The court monitors the creditors' meeting by (1) appointing the chairperson of the creditors' meeting from among the creditors with a right to vote; (2) determining the powers of the creditors' meeting; (3) convening the first creditors' meeting; (4) ruling on the creditors' property management solution and the bankrupt assets' pricing solution when the creditors' meeting fails to pass the solutions through a vote; (5) ruling on the distribution solution of thebankrupt assets when the creditors' meeting fails to pass it through a vote; (6) providing written approval of the establishment of the creditors' committee; (7) approving, by administrator's or debtor's petition, the draft reorganization plan if it has not been adopted; and (8) ratifying the adopted draft reorganization plan.

• Relationship between the administrator and the self-governing creditors' meeting and committee

The creditors' meeting and the creditors' committee oversees the administrator's performance of duties. In addition, the administrator attends the creditors' meeting as an observer, reports his/her work to the meeting, and makes related inquires. Regarding the administrator's performance of duties, the creditors' committee may require the relevant personnel of the administrator or the debtor to explain or provide documents on the matters within their authority. The administrator must make timely reports to the creditors' meeting of his/her acts.

VIII. Bankruptcy Remedies

Under the previous legal framework, the court's ruling was final, in most cases.However, the previous legal framework lacked necessary monitoring and restrictions among interested parties, such as the debtor, the creditors, the self-governing organs of the creditors and the liquidator. To better protect the interests of all parties, the New Law provides the following remedies.

• Judicial remedies for the creditors and the debtor

（1）Disagreement: The debtor may challenge petitions for bankruptcy when creditors petition the court for bankruptcy of the debtor.

（2）Appeal: Petitioners may disagree when the court dismisses a bankruptcy petition and appeal to the court at a higher level. Petitioners may also appeal when courts reject bankruptcy petitions.

（3）Legal action: If the debtor or the creditors disagree with the claims specified by the claim sheet, the disagreeing party may initiate a legal action at the court that accepted the petition for bankruptcy.

（4）Reconsideration: The creditors may apply for reconsideration by the court, if a party disagrees with the creditors' property management solution or bankrupt assets pricing solution or a party whose claims represent more than half of the total claims disagrees with the bankrupt assets distribution solution.

（5） Petition for annulling the resolution: If creditors believe that the resolution of the creditors' meeting violates the law and impairs their interests, those creditors may petition to annul the resolution and order the meeting to form a new resolution legally.

• Remedies for Creditors' Meeting or Creditors' Committee against the Administrator

（1） Changing the administrator: If the creditors' meeting considers that the administrator is not able to perform the duties legally or fairly or the administrator is incompetent, it may petition the court to change the administrator.

（2）Disagreement: If the creditors' meeting disagrees with the administrator's remuneration, it may file a petition with the court.

（3）Making decisions on matters under supervision: If the personnel of the administrator or the debtor rejects the supervision of the creditors' meeting or the creditors' committee and such rejection violates the New Law, the creditors' committee may file a petition with the court for a ruling regarding the matter under supervision.

IX. Issues Regarding Reorganization

• Special restriction on rights and interests of related parties during reorganization

Different from liquidation, the purpose of reorganization is to help the debtor survive its financial crisis. Therefore, special restrictions are imposed on the exercise of the rights and interests of related parties during reorganization.

(1) On the administrator: The debtor may manage his/her own property and business upon petition and the court's approval; The administrator only performs his/her duty as the supervisor.

(2) On the guarantor: The guarantor must suspend the exercise of the guarantor's rights.

(3) On the right of profit distribution of the equity holders: The equity holders of the debtor may not request distribution of the return of investment.

(4) On the equity transfer of senior officers: The directors, supervisors, and senior executives of the debtor may not transfer the debtor's equity that they hold to a third party, except for transfers approved by the court.

(5) On the right of reclamation: When the debtor legally occupies a third party's property, the owner of such property may petition for return of the property upon the agreed terms during reorganization.

• Voting on the Reorganization Plan

The New Law provides that the creditors may vote on the reorganization plan in groups, which embodies one of the principles of the bankruptcy law—the reorganization plan may treat the creditors in different classes differently, but must treat the creditors' in the same class fairly. The New Law states that all members of a group must have the same interests. A reorganization plan is deemed adopted when all voting groups pass the draft reorganization plan. If the voting group fails to pass the draft reorganization plan and refuses to vote again or fails to pass the plan on its second voting and the draft plan satisfies certain requirements, then the debtor or administrator may petition for the court's approval.

X. Issues Regarding the Bankruptcy of Financial Institutions

When financial institutions encounter material operational risks, the creditors or debtor may initiate liquidation or reorganization but may not initiate conciliatory settlement. Since risk management of securities companies usually combines administrative measures and bankruptcy proceedings, the law grants competent authorities the power of petitioning for bankruptcy. The New Law provides that a competent authority may petition to suspend civil litigation or enforcement against a financial institution if the institution is placed into receivership or custody. This arrangement is crucial to bridge risk management of financial institutions and bankruptcy proceedings. The arrangement is acceptable, however, it is better not to include it in the bankruptcy law, since this is not an issue to be resolved by bankruptcy proceedings. Instead, it would be more appropriate to set forth such a provision in the laws and regulations governing risk management of financial institutions.

(The article was written in Chinese, the English version is the translation.)

* Zhang Ting is an associate at Litigation & Arbitration Group, King & Wood's Beijing office.

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