The New Chinese Bankruptcy Law: One Of The Foundations Of A Mature Market Economy

Friday, December 1, 2006 - 00:00

Editor: Would each of you gentlemen give our readers some idea of your professional experience?

Palmer: By training, the two of us are restructuring and bankruptcy lawyers. I have been at the firm for 25 years, and John is a year or two behind me. We are partners in the Business Finance & Restructuring Department of the firm.

Rapisardi: I started at Weil Gotshal after having clerked with the United States Bankruptcy Court in the Southern District of New York. Over the past 20 years I have handled a mix of debtor and creditor matters, and I have represented a number of large financial institutions as creditors in Chapter 11 cases. During the past year Deryck has brought me into his work with respect to the new Chinese bankruptcy law.

Editor: Speaking of the new law, what is the background of your involvement?

Palmer: Our work began in 1999, when we were asked to consult on a specific bankruptcy provision. That led to additional consultations, and we found ourselves asked to comment on a number of aspects of the Chinese bankruptcy regime. There is an intense desire on the part of the Chinese to modernize their bankruptcy system, particularly since China has become a member of the World Trade Organization, but the authorities are mindful of the country's cultural and social fabric and desire to take this step without fostering wholesale layoffs in the workplace. We have been conscious, in our own work, of the difficult balancing act that underlies their efforts. China has made tremendous strides in becoming a mature market economy, and while it is not there yet, this legislation represents a step forward in that journey.

Rapisardi: There is a keen interest on the part of all the investment funds in the development of a bankruptcy code that is predictable. It has become very clear to us as restructuring professionals that if the Chinese government supported a bankruptcy code that included the concepts that underlie such codes in the West, mandated the training of a judiciary capable of consistently applying such a code and oversaw its fair and impartial implementation, there would be great opportunities for Western and specifically U.S. practitioners. Even though we would not be practicing Chinese bankruptcy law, our experience and expertise would be of considerable value to the investment funds, financial institutions and others attempting to navigate through a new bankruptcy system.

Palmer: Since 1999 I have made 14 trips to China. The Chinese address problems from their perspective, which is not necessarily ours, and they tend to bring uniquely Chinese solutions to the problems they face. There are more than 2,000 state-owned enterprises that are in financial distress at the moment, for example. Modern restructuring wisdom would have a turn-around expert come in and require a reduction in the work force to reduce costs. That, however, could result in destabilizing entire districts where such enterprises are located. The Chinese compromise is to give priority to employee wage claims, depending on when they accrued, which means, in effect, that employees are secured creditors in certain circumstances.

Editor: What is the reasoning behind the new statute? Why was it considered necessary to enact a new bankruptcy law?

Rapisardi: The concept of bankruptcy law is not foreign to the Chinese. They had a bankruptcy law on the books as far back as 1906. The revolution of 1949 abolished all of that. When China began to open its doors to the West in the early 1980s, however, it was apparent that some sort of mechanism was necessary to permit companies - at this point, all state-owned - to liquidate. In 1986 a limited law was passed, and this was later extended, in 1991, to the newly emerging enterprises that were not state-owned.

The present law has a much greater scope than those enacted in 1986 and 1991. It constitutes a single body of law that extends to both state-owned and private enterprises. It allows for both voluntary and involuntary petitions, provides for a debtor-in-possession and, in general, encourages the concept of reorganization.

Palmer: Let me mention that the new law allows the Chinese entity to take advantage of one of the procedures we take for granted in the U.S. - the debtor-in-possession concept. The enterprise can utilize the experience and expertise of the people who have been running the business.

Editor: Why now? Does China's entrance into the WTO have anything to do with this?

Palmer: The bankruptcy law is one of the laws that China is on course to implement so that it can enter into international commercial markets and be a full-fledged member of the WTO. This law, as well as the partnership law, is now being examined as part of this effort.

Rapisardi: It is important because China is trying to encourage investment in its economy. That means attracting outside investors and lenders. Lenders want to know what the exit strategy will be for an entity operating under Chinese law which becomes distressed. They want to know their rights and remedies in such a situation, and a familiar roadmap gives them a certain comfort level.

Editor: Are there practitioners who are capable of practicing in this arena, and are there judges who are capable of objectively and fairly enforcing it?

Palmer: I believe that the judges will be capable of interpreting and applying the provisions of the new law in an appropriate way. It is in China's best interests to have all of that in place, and I believe that education and training are underway to achieve such an end. As for the licensing of administrators, that discussion is still underway. To the extent that China desires to attract foreign investors and lenders, it is important to have expert restructuring professionals in place as well. The expertise is available to them - I am thinking of Hong Kong and other accountants with extensive restructuring expertise - but no public announcements have been made as yet.

Editor: What are the high points of the statute?

Palmer: There are three basic segments: restructuring, liquidation and conciliation. Restructuring is tantamount to Chapter 11, with insolvency being required for eligibility to file a voluntary petition. Insolvency means the inability of the organization to pay its debts and entails the examination of its balance sheet. Liquidation is self evident, and conciliation is similar to an out-of-court wind-down in the U.S. system.

The scope of the new law is pretty broad. It does not apply to partnerships, but it does cover just about every type of corporate entity, including state-owned corporations and corporations which are not state-owned.

Editor: How is an administrator appointed?

Rapisardi: An administrator is appointed by the court on the granting of the application for bankruptcy. As late as the July 2004 draft there was some controversy as to whether the court-appointed administrator could be replaced by the creditors at the first creditors' meeting. This has now been answered: no. The creditors can request the court to dismiss the administrator and designate a new one, however.

Palmer: Another issue - and one that has not been addressed - is how administrators are to be paid. Out of the funds of the bankrupt estate, by the government or by a third party? That awaits resolution.

Editor: When a bankruptcy application is accepted, what impact does this have on a creditor's actions against the debtor?

Palmer: When the application is accepted, the creditors are prevented from taking any further action . But, there is a 15-day period from the filing of the petition and its acceptance or rejection, and during this period the creditors can continue to pursue their interests. John and I have advocated that this provision should be revised so that the automatic stay begins with the filing.

Rapisardi: There is also a delay in the appointment of the administrator until the application is granted. In having the automatic stay apply upon filing, we also advocate the possibility of an interim appointment of an administrator. This is the case in the U.S. with respect to involuntary bankruptcy, where an interim appointment is available if the assets are thought to be in jeopardy.

Editor: You alluded to employee claims taking precedence over those of a secured creditor. Won't this have a dampening effect on foreign investors and lenders?

Palmer: At this point it is speculation to project the impact that the new law is going to have on foreign investors and lenders. In restructuring, the first question is always what due diligence can be undertaken to determine what is available. Here, if the assets are worth six million and the employee claims come to five million, you have something to work with. The next question has to do with determining when the employee claims accrued - before or after the enactment of the law - and, accordingly, which buckets they fall into. There is a differentiation of treatment depending on when the claims accrued.

I hasten to add, with respect to your question on the dampening effect of employee claims taking precedence over secured creditors, the single most important thing that foreign investors and lenders are looking for is predictability. They wish to know where they stand going in. And I think the new law gives them that.

Rapisardi: I should point out, in addition, that the rules with respect to employee claims having priority remain in effect until 2008. What happens after that, however, is unknown.

Editor: Is the new bankruptcy law a step forward in China's development of a market economy? Will it lead to an increase in foreign investment?

Palmer: There is now predictability for investors. They can analyze the risk factors, and they know what the worst case is for restructuring. That enables them to appropriately price the level of return they need to compensate their shareholders. That is the benefit of the new statute.

Rapisardi: Foreign lenders will be watching to see how the new law is applied. If the perception is that it is applied consistently and in an impartial and objective manner, they will be greatly reassured. That, in turn, will be of great benefit to the Chinese economy.

Editor: What about the future? What needs to be done to make the Chinese bankruptcy regime in compliance with international norms, or, putting it another way, reflective of a fully mature market economy?

Palmer: There are three things remaining to be done: the promulgation of rules and regulations to support the bankruptcy law; the training of a judiciary to implement the law in a fair and objective way; and the emergence of a perception of predictability in application. The first two are underway. The third remains for the future. Considering what is at stake, I believe the Chinese will accomplish that as well.

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