Background
China's old bankruptcy law, the 1986 Enterprise Insolvency Law (Trial Implementation), was promulgated for trial implementation in 1986 following the start of China's economic reform in 1978. During the Asian financial crisis however, the shortcomings of the 1986 Bankruptcy Law were exposed in a number of major bankruptcies in China, including the high profile GITIC bankruptcy. Therefore, as China's economy integrates further into the world economy under WTO, the reform of the Bankruptcy Law (which started in 1994) was considered one of the top legislative priorities for China.
Now, having taken twelve years of drafting and three highly controversial readings at the Standing Committee of the National People's Congress, the new bankruptcy law was finally passed into law on August 27.
Principal Features Of The New Law
The new bankruptcy law has a number of notable features including:
1) Scope of application: The 1986 law was originally drafted to apply only to state-owned enterprises (SOEs). In contrast, the new law applies to all enterprises with legal person status, including financial institutions, non-SOEs and foreign invested enterprises. There are three bankruptcy procedures under the new Bankruptcy Law comprising liquidation, reorganization and reconciliation.
2) Universal application: Unlike the 1986 law, the new law seeks to deal with cross-border insolvency issues. For example, it expressly applies to the bankrupt's overseas assets outside China.
3) Administrator: The law introduces a new role of administrator which takes over the function previously discharged by the liquidation committee under the 1986 law. In addition to officials from government departments, professionals such as lawyers and accountants may now be appointed as administrators. Strict qualification requirements and duties of an administrator are also stipulated in the law.
4) Reorganization: Either the debtor or the creditor may petition to the court for a reorganization proceeding. During reorganization, the debtor may manage its assets and conduct business under the supervision of the administrator, and any security held by secured creditors cannot be enforced against the debtor.
5) Reconciliation: The debtor may petition to the court for a reconciliation proceeding and to that end may present to the court a reconciliation proposal. If the proposal is agreed by a simple majority of creditors holding not less that two thirds of the unsecured debts, it will become binding on all unsecured creditors. Secured creditors may continue to enforce their rights during reconciliation.
6) Ranking of claims: Once the court makes a liquidation order, the debtor's assets will be realized and applied in accordance with the prescribed ranking. Secured creditors will be paid out of secured assets. Out of the general assets, any insolvency fees, wages and other labor-related payments and tax payments will be paid first, then any debts due to unsecured creditors will be paid.
Importantly, there is a transitional provision giving wages and certain labor-related payments incurred prior to August 27 (the date of the passing of the new law) priority over secured creditors.
7) Preferences and claw-back provisions: Under the Law, a transaction may be subject to avoidance in a wide range of situations. Firstly, a fraudulent transfer of asset by a debtor is void ab initio. Then, certain non-arm's length transactions effected within one year prior to the acceptance of the bankruptcy petition, such as the provision of security for previously unsecured debt, transactions at under-value, early repayment of debts, or abandonment of creditor's rights by a debtor, may be set aside. Furthermore, repayment of debts made within six months prior to the acceptance of the bankruptcy petition, where the debtor was insolvent at the time of payment, may also be subject to avoidance.
8) Personal liability: The new Bankruptcy Law imposes civil and, in some cases, criminal liability on the directors, supervisors and senior officers of the bankrupt entity if they breached certain duties or committed certain wrongs under the new Bankruptcy Law
Key Issues Affecting Derivatives
Close-out netting and set-off
A commonly raised question in relation to derivatives with a Chinese counterparty is the enforceability of close-out netting provision. It is understood that there is no distinct legal concept of close-out netting under Chinese law. Accordingly, it is likely that the enforceability of close-out netting provisions will be considered in the context of insolvency set-off under Chinese law.
Under the interpretation rules in respect of the 1986 law issued by the People's Supreme Court in 2002, after the commencement of a bankruptcy proceeding, a creditor may apply to the liquidation committee to set off the debt owed by an insolvent company against any debts owed to the insolvent company. Accordingly, it appears that a creditor is not entitled to set-off against the bankrupt but is only entitled to apply to the liquidation committee to set-off. Since the set-off is not a "self-help" remedy, the enforceability of close-out netting provisions is generally considered to be doubtful under the 1986 law.
Under the new law, a creditor may now assert a right of set-off against the administrator in relation to what it owes to the bankrupt against the debts owed to it by the bankrupt. Of course any such assertion by a creditor may still be subject to the subsequent challenge by the administrator, but such challenge by itself should not invalidate any set-off effected in accordance with the new law. However, the new law does not expressly require the creditor to apply to the administrator for effecting set-off. Does this mean the assertion of the right of set-off by a creditor under the new law is not subject to the prior approval of the administrator, and may be considered to be a self-help remedy? In this regard, it is interesting to note that a similar language of "asserting a right of set-off" is also used in the set-off provision in China's Contract Law, which is generally considered to be a self-help remedy (subject only to the giving of notice). In the end, it may be that this important issue can only be clarified by the interpretation rules to be made by the People's Supreme Court. However, there is now scope for close-out netting to be treated more favourably under Chinese insolvency law.
Right of termination and cherry-picking
The new law provides that, after the court has accepted a bankruptcy petition, the administrator has the right to decide whether to continue or disclaim any executory contract i.e. agreement under which both parties have outstanding obligations to perform, and to notify the counterparty accordingly. If the administrator fails to notify the counterparty of its decision within two months, or fails to respond within 30 days after receiving the counterparty's request, then the agreement is deemed terminated.
The pre-requisite of close-out netting is the ability to terminate all transactions. Given that the administrator has a right to cherry-pick any agreement, it appears that the counterparty will not have a right to terminate transactions until after such standstill period. This can be problematic to a creditor who hopes to terminate and net off transactions as soon as possible in the face of a volatile market.
In addition, the new law provides that, in cases where the administrator decides to continue with a particular agreement, the counterparty has the right to require the administrator to provide collateral. If the administrator fails to provide collateral, the agreement is deemed terminated. It would seem desirable for the claim of the counterparty (who does not have a right to terminate where the administrator decides to continue with the agreement) to become a secured claim. What is not clear however is whether the collateral will be subject to the satisfaction of the counterparty and of certain credit quality.
Conclusion
The enactment of the new Bankruptcy Law marks another milestone in the development of an increasingly international and sophisticated economy in China. The People's Supreme Court in China announced in early September that a working group had been set-up to draft the interpretation rules to the new Bankruptcy Law. To this end, it is hoped that important issues, including the enforceability of close-out netting and the termination right, will be further and better clarified in the interpretation rules before the new Bankruptcy Law comes into force on 1 June 2007.
This week's Learning Curve was written by Chin-Chong Liew, partner, and Benjamin Liu, managing associate, at Linklatersin Hong Kong.
