The Evolution of Chinese Bankruptcy Law: Challenges of a Growing Practice Area Richard C. Pedone Partner Nixon Peabody LLP Henry H. Liu Partner DLA Piper LLP (U.S.) Bankruptcy Cases in China During 2009, approximately 2,900 bankruptcy cases were filed in China, which is down from 3,139 in 2008 and 3,810 in 2007.1 The number of bankruptcy filings in China is relatively low compared to the U.S., where, for example, in March 2009 alone, 8,162 business cases were filed.2 Rarity of Bankruptcy Cases in China and Explanations Therefore Some commentators have posited a number of theories for the relative rarity of bankruptcy cases, including the significant impact of local governments in deciding whether a business should enter bankruptcy and the incentives of not allowing companies to enter into bankruptcy.3 Brief History of Bankruptcy Practice in China. China has a relative short bankruptcy practice history. A bankruptcy law was first introduced in China in 1906, during the last years of the Qing Dynasty, which met its demise in 1911. Bankruptcy laws were later issued in 1915 and 1935 during the Republic of China period, which ended in 1949 when the People’s Republic of China was founded. For more than thirty years after 1949, there was no bankruptcy system in practice. In 1986, the first bankruptcy law for state-owned enterprises was promulgated. Bankruptcy and insolvency for private companies and foreign-invested companies continued to be governed by separate laws. The Enterprise Bankruptcy Law (EBL), which is more broadly applicable, became effective in 2007. 1 Li Shuguang and Wang Zuofa, Review of the PRC Bankruptcy Law in 2009, March 2010, INSOL International, Technical Series Issue No. 11. 2 See http://www.totalbankruptcy.com/blog/bankruptcy-filings-at-post-2005-high/. There were 149,979 personal bankruptcy cases in the U.S. filed during March 2010. China currently does not have law providing for personal bankruptcy. 3 See e.g., Li Shuguang and Wang Zuofa, Review of the PRC Bankruptcy Law in 2009, March 2010, INSOL International, Technical Series Issue No. 11; Steven J. Arsenault, The Westernization of Chinese Bankruptcy: An Examination of China’s New Corporate Bankruptcy Law through the Lens of the UNCITRAL Legislative Guide to Insolvency Law, 27 Penn St. Int’l L. Rev. 45 2008-2009. “Policy” Bankruptcy Policy bankruptcy refers to the process under which the government in China promoted the bankruptcy of certain money-losing state-owned enterprises. Policy bankruptcy formally came to an end in 2008, though pending cases continued thereafter. The primary concern of these cases often has been the compensation of employees who relied on the prospect of lifetime employment in state-owned enterprises. In many cases, national, provincial, and local governments funded the compensation of these employees. Debts owed to state-owned banks were also often forgiven in order to provide employees with a distribution. Without the government subsidy to support policy bankruptcies, state-owned companies now have less incentive to file for bankruptcy. Currently, bankruptcy and liquidation of state-owned enterprises and the subsequent compensation of employees continues to be an important issue faced by these enterprises and governmental entities. Bankruptcy Courts Because the EBL became effective relatively recently, China still generally lacks specialized bankruptcy courts, judges, and professionals familiar with bankruptcy proceedings. In a recent interview, which was posted on the Web site of the Supreme People’s Court on February 24, 2010, an official from the Supreme People’s Court4 indicated that there is a lack of experienced and capable administrators in China, which results in administrators looking to the court for directions on relatively minute issues, thereby decreasing the efficiency of these cases. The official also noted a need to develop judges with expertise in bankruptcy, and when resources permit, to establish special departments and courts for bankruptcy proceedings. The Enterprise Bankruptcy Law The EBL, like other PRC statutes, was drafted at a “high level” and lacks details present in other insolvency statutes around the world.5 The Supreme People’s Court, the highest court of the PRC, has promulgated several judicial interpretations and rules on the EBL, which pertain to specific areas including 4 See Q&A with the Head of Supreme People’s Court Second Civil Department, http://www.court.gov.cn/spyw/mssp/201002/t20100224_1899.htm. 5 For example, the U.S. Bankruptcy Code and the U.S. Federal Rules of Bankruptcy Procedures. the appointment and compensation of administrators. A more comprehensive set of judicial interpretations and working rules is expected later in 2010.6 Currently, however, there are a number of legal issues that have been left relatively open. One of these issues is the lack of debtor-in-possession (DIP) financing. Article 75 of the EBL contains one sentence stating that secured DIP financing is allowed. However, unlike the U.S. Bankruptcy Code, the EBL does not specify details such as whether priming liens are allowed.7 As a practical matter, their lending to companies in bankruptcy is rare because there is no established market of firms providing DIP financing, and without clear rules, it would be difficult for such a market to develop. Some commentators have argued that the Enterprise Bankruptcy Law has been underutilized because 700,000 or so firms exited the market during 2008 and few used EBL proceedings.8 Most of these companies chose to “wind up “ under company law outside of court proceedings rather than make a bankruptcy filing when they exited the market due to insolvency.9 At the same time, the number of litigation cases in China has steadily risen according to statistics provided by the Supreme People’s Court of China,10 which would seem to suggest that the lack of bankruptcy filings is not caused by a general tendency to avoid courts or any reluctance to look to courts to resolve disputes. Notable 2009 China Bankruptcy Cases Some notable bankruptcy cases in 2009 included the following: Sanlu In November 2008, Sanlu, the producer of contaminated milk, whose executives were tried in high-profile criminal cases, declared bankruptcy.11 6 Li Shugang and Wang Zuofa, Review of the PRC Bankruptcy Law in 2009, March 2010, INSOL International, Technical Series Issue No. 11. 7 See 11 U.S.C. §364. 8 See supra note 6. 9 See supra note 6. 10 2009 Status of the Administration of People’s Courts, http://www.court.gov.cn/qwfb/ sfsj/201003/t20100312_2779.htm. 11 Milk scandal tainted Sanlu files for bankruptcy, CNN.com, http://www.cnn.com/2008/ BUSINESS/12/25/sanlu.bankruptcy/index.html. Its assets were sold in bankruptcy but the proceeds may not be sufficient to cover the tort liabilities.12 East Star Airlines East Star Airlines was the first airline case under the EBL. The case was filed in early 2009 in Wuhan.13 The East Star case was an involuntary case filed by a group of six creditors and contested by the debtor, which sought to reorganize. This case apparently resulted in quite a bit of public animosity between the petitioning creditors and the local government on one side and the debtor on the other side. The debtor stated that it would like to reorganize while the petitioning creditors, supported by the local government, favored liquidation. The effort to reorganize eventually failed and the East Star’s assets have now been liquidated. FerroChina FerroChina, 14 a case that was closely watched by foreign lenders as a “test case” for whether foreign creditors would receive treatment equal to similarly situated domestic creditors, was filed in Changshu, Jiangsu province. FerroChina had both foreign and domestic creditors. Its foreign creditors, among which were Citigroup Inc. and Citadel Investment Group LLC, were owed money by both its operating “onshore” subsidiaries in China and an “offshore” holding company. After FerroChina’s assets were sold to a state-owned enterprise, creditors to the “onshore” operating companies, both foreign and 12 Sanlu Group at heart of China milk scandal ordered bankrupt by court, Xinhuatnet.com http://news.xinhuanet.com/english/2009-02/12/content_10806837.htm. Some victims have attempted to sue Sanlu in Hong Kong. However, on May 27, 2010, the Hong Kong court ruled that the tort cases against Sanlu should be handled by courts in Mainland China. See http://www.thestandard.com.hk/news_detail.asp?pp_cat=11&art_id=98742& sid=28400804&con_type=1. 13 Administrator: East Star Airline’s reorganization is hopeless, chinainsol.org, http:// www.chinainsol.org/show.aspx?id=293&cid=3; East Star Airline’s assets liquidated, http://content.caixun.com/NE/01/uh/NE01uhop.shtm. 14 See FerroChina restructuring reassures foreign creditors, China Law & Practice, October 2009; Sub-prime, China Style, Euromoney, April, 2009; FerroChina Deal Struck: Some Paid, Others Get None; Minemetals Takes Units, The Wall Street Journal, September 3, 2009. domestic, received partial distribution, but there were no proceeds left to distribute to the holding company (i.e., the equity holder in the operating companies) or, by extension, to the holding company’s creditors.15 In the end, the foreign creditor did receive equal treatment, which reassured the community of foreign lenders. Special Treatment Companies While most cases under the EBL have been liquidations, there are some notable “reorganization” cases.16 For example, as of June 2009, there were sixteen filings involving insolvent listed public companies.17 Such companies, known as special treatment (ST) companies, typically enter into reorganization in order to sell their valuable “listed” status to an investor who purchases equity interest in the “shell” of the ST company and pays their existing creditors from the proceeds. There continues to be a market for the corporate “shells” of these ST companies.