PLI: Can you please explain China's Enterprise Bankruptcy Law?

YABO LIN: When China's first comprehensive Enterprise Bankruptcy Law (the "EBL") came into effect on June 1, 2007, many commented that it was powerful and near perfect on paper but seemed irrelevant as the country's GDP growth rate was going over 10% per year and credit was abundant. The EBL is now less than two years old, and there is little doubt about its relevancy in today's recessionary economy. China's economic landscape is not immune from the financial and economic difficulties that swept the U.S. and Europe. Official statistics show that 67,000 factories of various sizes were shuttered in China in 2008. It is estimated 100,000 will have closed by the end of 2009. As the number of failed companies rose, the young EBL is being tested earlier than the legislators expected.

The EBL modeled after various sources, including U.S., U.K. and European bankruptcy laws as well as China's 1986 enterprise bankruptcy law. Its modern approaches appear familiar to many U.S. bankruptcy practitioners, yet both its mechanism and implementation undoubtedly retain many distinctive Chinese characteristics.

Unlike the old 1986 enterprise bankruptcy law, the EBL is intended to uniformly apply the same procedure to virtually all business enterprises, including China's state-owned enterprises ("SOEs") and private enterprises such as foreign invested enterprises. Additionally, the EBL also recognizes foreign creditors. The progressive openness was welcomed with open arms by western investors as well as their counsel.

Many foreign bankruptcy concepts and procedures are incorporated, with certain variations, into the EBL. Under the EBL, the bankruptcy process begins with an application by an entity or its creditors. A formal proceeding does not commence until the court "accepts" the application. Unlike the U.S. Bankruptcy Code, which does not require insolvency before filing for bankruptcy under Chapter 11, China's EBL requires the applicant to be balance sheet insolvent, cash flow insolvent, or both. In a balance sheet insolvency, the fair value of the debtor's assets is less than its total liabilities. In a cash flow insolvency, the debtor cannot pay off its debts when they become due. After the court accepts an application for bankruptcy, any civil litigation, arbitration and other enforcement procedures involving the debtor's assets are automatically stayed. This timing differs from bankruptcy under the U.S. Bankruptcy Code, in which the stay commences automatically when a bankruptcy petition has been filed.

Reorganization, Reconciliation and Liquidation: The EBL makes three options available to a debtor in bankruptcy. The debtor can choose reorganization, reconciliation (i.e., compromise of creditors claims) or liquidation.

Reorganization: An entire chapter in the EBL is devoted to reorganization. Similar to Chapter 11 of the U.S. Bankruptcy Code, an entity can reorganize and stay in business under China's EBL if it elects reorganization. This is a significant move in China's bankruptcy law, as it shows that the Chinese legislators embraced the concept that the value of a faltering company can be better preserved through reorganization than liquidation. This concept is unremarkable to many western scholars and professionals in the field, but for a socialist country where market economy was once non-existent, it was a novel idea, and fortunately, not any more.

In order to elect reorganization, the debtor (through an administrator or, in rare instances, management) must submit a reorganization plan to the court. Creditors, including classes of secured creditors, employees, taxing authorities and unsecured creditors, are then given the opportunity to vote on the plan. If the plan is accepted by the requisite number of creditors voting in the respective class (half in number of creditors eligible to vote, representing two-thirds or more of the total debt), the debtor may reorganize. If one class of creditors does not accept the plan, so long as the plan meets certain specified requirements, including fair treatment for that opposing class, the court can still approve the plan over the objection of the dissenting class.

Reconciliation: Reconciliation gives unsecured creditors an opportunity to settle with the debtor or compromise on their claims much like state court compositions in the U.S. The amount of a creditor's claims must be confirmed by the court. After approval by more than half of the creditors with the right to vote at the meeting who hold at least two-thirds of the unsecured debt, the proposed reconciliation agreement can be submitted to the court for approval. A secured creditor may exercise its right as of the date on which the court rules on a reconciliation agreement.

Liquidation: As in Chapter 7 of the U.S. Bankruptcy Code, in a liquidation under China's EBL, an entity will be shut down and its unencumbered assets liquidated to pay claims according to the following distribution priority: first, wages and subsidies for medical treatment, then disability payments, social security payments, insurance premiums, tax and related fees, and finally general unsecured creditors. Secured creditors do have priority with regard to the specific assets that are used as collateral for their secured credit. If a secured creditor's collateral is insufficient to satisfy its claims, the unsatisfied portion is deemed unsecured and will join the rest of the unsecured debt for distribution.

Creditors' Meeting and Creditors' Committee: Any creditor who declares its creditor's right according to law (or "asserts a claim," as it is called in the U.S. Bankruptcy Code) and whose right has been confirmed by the court may be a member of the creditors' meeting. Such a creditor has the right to attend and vote at the meeting. A resolution may be adopted by more than half of the creditors with the right to vote at the meeting who hold at least half of the unsecured debt. A creditor whose creditor's right has not been affirmed by the court generally is not entitled to vote.

At the creditors' meeting, many important decisions are made, including those concerning whether or not to adopt a proposed reorganization plan, whether to continue or terminate the debtor's business operation, and how to supervise the bankruptcy administrator.

The creditors' committee consists of no more than nine creditor representatives, including an employee representative or a union representative. The creditors' committee is authorized to supervise the management and disposition of the debtor's assets, supervise the distribution of the debtor's assets and hold meetings of other creditors. Creditors also have set-off and reclamation rights that are similar to those rights under the U.S. Bankruptcy Code.

The Administrator: The role of an administrator under the EBL is similar to that of a Chapter 7 or Chapter 13 trustee appointed by the trustee's office in the U.S. Under the EBL, however, appointment of an administrator is mandatory in a reorganization case where the debtor in possession still runs the business. Upon acceptance of the application, an administrator, which may be a disinterested law firm or accounting firm, is appointed and, in most cases, granted broad authority over the assets and affairs of the debtor. The debtor management may petition the court to, and in many cases do, remain in possession in a reorganization under the close supervision of an administrator. The administrator's authorities and responsibilities are also similar to those of a trustee under the U.S. Bankruptcy Code, including:

• the right to pursue preferential payments made to a creditor within six months of the date the application was accepted;
• the right to avoid conveyances made for less than fair consideration within a year before the application was accepted;
• the authority to assume or reject contracts which remained executory when the application was accepted;
• the authority to operate or discontinue the business;
• the authority to continue pre-filing civil litigation;
• the right to dispose of assets;
• the authority to analyze and object to creditor claims; and
• the right to hire staff (including the debtor's management) and incur expenses

The People's Supreme Court of China issued two sets of judicial decrees in 2007, one governing the appointment of administrators and the other regulating their compensation. These rules require the provincial high courts and the municipal intermediate courts in China to compile an administrator roster for their respective jurisdictions. It is usually the case that only individuals and entities listed on the roster can be appointed as administrators by the courts. To qualify as an administrator, an individual or entity must be a legal Chinese resident. As a result, foreign bankruptcy professionals or firms are precluded from directly taking on such roles, yet they can still act as counsel to the Chinese administrators in bankruptcy cases