Vol 2 (2005) - Issue 6

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Moving China’s Goalposts

The forthcoming reform of China’s bankruptcy sector will have some major implications to investors in China.

A draft new bankruptcy law, introduced last year, signalled some possible major changes to China’s investment climate. The new law was scheduled for its third and final reading before the Standing Committee of the National People’s Congress (‘NPC’), China’s top legislature, in April 2005 and was expected to be enacted. However, it was not passed, and now appears to have been delayed until the next meeting of the NPC. The main outstanding issue is thought to be whether workers’ rights should be given priority over the claims of secured creditors.

This article looks at the current state of play, the issues under debate, and the relevance that the new law’s enactment could have on international business.

Background and the need for reform

The problems with China’s current bankruptcy framework are numerous, but in very general terms could be summarized as follows:

- China does not yet have a unified bankruptcy law that applies throughout the country and to all types of debtor entities. The current bankruptcy laws lack detail and depth in many aspects and have to some extent become outdated.

- Depending upon the type of entity in question, the approval of the Ministry of Commerce, or of some other governmental or regulatory body, may be required before bankruptcy procedures can be initiated.

- The rules and regulations focus on the issues of resettling employees and reallocation of existing business/assets to other economic usage – only leftovers are paid to creditors.

- Creditors have very few legal rights or remedies, and very limited opportunity to participate in the bankruptcy process. As a result, laws enabling pre-bankruptcy transfers defrauding stakeholders to be reversed are often not enforced in practice. Similarly, disposals of assets in the bankruptcy are not always handled in a way aimed at maximizing recoveries.

- There is limited involvement of the courts and in any event there is no independent judiciary with legal or other expertise in bankruptcy matters.
- China’s laws and regulations are not generally conducive to corporate restructuring or reorganization.

The Chinese authorities’ decision in 1998 to formally place GITIC (Guangdong International Trust and Investment Corporation) into bankruptcy proved a painful experience. Many foreign banks had made loans on the understanding that such loans were backed by the provincial government, only to find that the provincial government was not prepared to stand behind GITIC and repay them. One result was a reappraisal of risk management by foreign banks. Further, the inefficiencies, opacity and credit-unfriendliness of China’s existing bankruptcy framework were exposed for the world to see.
Chinese authorities recognize that the current bankruptcy system is not adequate to meet the needs of China’s economic system today and that an efficient system is an essential cornerstone of China’s effort to build a market economy.
They also recognize the need to improve and reform China’s social security structure, to cater for the millions of workers who might be laid off through bankruptcy procedures, with consequential risk of social unrest.
Another priority has been the need to reform many state-owned enterprises and financial institutions into viable enterprises (through corporatization, privatization or internal restructuring), capable of surviving a market economy, private-sector competition and an efficient bankruptcy regime.