The breakdown on bankruptcy

After more than a decade of debate, China has clarified its bankruptcy rules, which up until now have allowed loss-making state companies to keep operating instead of being closed down.

The national legislature’s recent passage of a new unified bankruptcy law is aimed at being more in line with international practices, giving creditors of at-risk enterprises greater clout.

The much-anticipated law reflects Beijing’s desire to create a more orderly legal environment for the restructuring and closure of its state-owned enterprises (SOEs) and, for the first time, private companies as well.

“To support the establishment of the private sector, you need legislation like this,” says Susan Munro, a Shanghai-based lawyer with O’Melveny & Myers. “It will provide a certain basis for restructuring processes going forward.”

Ms Munro says that while the new law does not specifically mention foreign-invested enterprises, they are expected to be afforded similar legal protections to domestic private enterprises.

Bankruptcy rules in China have long operated in a grey area and been outdated. In spite of the country’s thriving market economy in recent years, its bankruptcy processes are from a bygone socialist era.

Promulgated in 1986, the current enterprise bankruptcy law only addresses procedures for SOEs. It was enacted at a time when China’s private economy was still in its infancy and there was only scattered foreign investment.

Even though this law was implemented on a “test basis”, it has been in effect ever since. As a result, the legal parameters for bankruptcy have become ambiguous, at times left to local government fiat.

The new law, which was passed at the weekend by the National People’s Congress and is expected TO be effective from June 1 2007, is greatly broadened in scope. The drafting process has been unusually meticulous.

Drafting started more than 12 years ago, and has involved many top legal scholars. There have been several revisions and delays within the past two years alone.

It is believed Beijing will release specific implementing regulations for the law, which has double the number of chapters of the old one, in the weeks or months ahead.

A big reason the drafting has taken so long is the deep-seated uncertainty within Beijing over how to deal with struggling SOEs and their army of government employees. Liquidating the assets of a failing SOE can take months, sometimes even years.

Cheng Siwei, vice-chairman of the NPC standing committee, says the final version represented a “compromise” that is intended to protect the interests of creditors as well as workers of insolvent enterprises. While legislators and lawyers agree it is likely to take some time before the law’s effectiveness can be gauged, many expect local court proceedings for bankruptcy cases will become more systematic and ­frequent.

Even though many SOEs are in financial difficulty, it is unlikely the new law will prompt a wave of closures across the country. Beijing’s leaders have tried to engineer a delicate balance between shutting-down state companies and appeasing millions of laid-off workers.

China’s leaders view widespread unemployment as a threat to local economies and, more important, to social stability. The central government has been urging state companies to establish internal risk-control departments to prevent sudden ­collapses.

In addition to offering greater protection for creditors, legal experts say it is likely that the law will over time expedite the reorganisation or liquidation process for debtors.

The legislation requires failed enterprises to pay their creditors first and then use the remaining funds to compensate workers, the official Xinhua news agency reported. Under previous rules, payment of workers’ wages was the priority.

But there are likely to be a few exceptions along the way. Xinhua noted that the new rules will not apply to some 2,000 state enterprises that are expected to announce bankruptcy by next summer, with Beijing allocating Rmb33.8bn ($4.3bn) for worker lay-offs at those companies.

Apart from domestic SOEs, the law outlines specific provisions for the bankruptcy of financial institutions, including securities brokerages, banks and insurance companies. But OMM’s Ms Munro says it is likely to be the government regulator – and not the financial institution itself – that will take the lead in such bankruptcy proceedings.

She adds that the new law should further help clarify procedures for cross-border insolvency cases and for foreign investors purchasing distressed assets in China.

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