[ABSTRACT] Article 31 of the Enterprise Bankruptcy Law provides that if an enterprise transfers its property at a manifestly unreasonable price within one year of entering bankruptcy proceedings, the administrator shall be entitled to motion the People’s Court to revoke the transfer. The purpose of such revocation is to recover the property for the benefit of all creditors of the bankrupt enterprise. When determining whether or not the price of a certain transaction is “manifestly unreasonable”, all information related to the transaction (including the relationship between the parties, their previous course of dealing, the property at issue and the composition of the transaction price, among other factors) must be taken into consideration. Sometimes it is also necessary to resort a third-party assessment of the property at issue.

[KEYWORDS] transaction price, manifestly unreasonable, revoke, property evaluation

1. Transactions Requiring Special Attention

The purpose of a trading party in setting a “manifestly unreasonable price” in a transaction is to profit, which means either to directly or indirectly benefit itself or to directly or indirectly benefit a related party. Consequently, when there is a relationship between the trading party and the other party that is easy to profit from, attention should be given to the transaction and it is necessary to examine the reasonableness of the transaction price. With respect to a “relationship that easily yields profits”, the author suggests referring to the definition for the term “related parties” in the Accounting Standards for Business Enterprises No.36 - Related Parties Disclosures , i.e. the examination should focus on transactions between the bankrupt enterprise and its related parties.

Appropriate attention should also be paid when the following circumstances are present in the transactions of the bankrupt enterprise:

  1. If the bankrupt enterprise’s buy-in property or interests are not within its scope of business, or if the buy-in occurs during the period during which the enterprise discontinues its operations; or
  2. If the bankrupt enterprise’s selling property or interests are not within the buyer’s scope of business;
  3. If the bankrupt enterprise’s selling property or interests represent important property or interests, e.g. a manufacturing enterprise selling its factory building, an entire set of manufacturing equipment or core IP rights, or an investment management company selling equities that it holds in another company;
  4. Transactions with specific content between the bankrupt enterprise and the trading party occurred in the past, but changes were evident in the content of recent transactions;
  5. There was no prior transaction between the bankrupt enterprise and the trading party, but their recent transaction involved a relatively large amount; or
  6. The transaction between the bankrupt enterprise and the trading party was not entered into in timely compliance with accounting rules.

Besides, since an audit institution is generally retained to conduct auditing of the bankrupt enterprise’s financial conditions during bankruptcy liquidation, the institution can be required to focus on and disclose transactions involving manifestly unreasonable prices based on its auditing experience.

2.  “Discovery” of True Transaction Prices

A decision on an alleged “manifestly unreasonable price” must be made through a comparison on the basis of the true transaction price. Therefore, when determining whether or not the price of a transaction is “manifestly unreasonable”, it is of first priority to “discover” the true transaction price. If the trading party faithfully enters the transaction price into its accounting books, there will not be an issue of “discovering” the true transaction price. However, in practice the trading party usually disguises the true transaction price to make it look reasonable and thereby avoid discovery of the improper profit conveyance.

Disguising the true transaction price in practice includes (without limitation) the following methods:

  1. In a buy-in at a high price, the property at issue is a combination of a number of articles or rights and interests, some of which are of low value; and the purpose of including such low-value articles and/or rights and interests into the transaction target is only to “make up the number”;
  2. In a buy-in at a high price, in addition to the consideration for the property at issue, a number of transaction-related expenses are fictitiously listed as being borne by the buyer; or a circumstance that results in the buyer’s default is fabricated, so that in addition to the consideration the buyer is also liable to “indemnify” the opposing party in the name of “liquidated damages” or “compensation”.
  3. In a sell-out at a low price, defects are fabricated in the sold property, in the rights and interests, or in the quality, quantities and rights, so as to depreciate the value;
  4. A third party (including a property evaluation institutions) is persuaded to fraudulently issue a third-party certificate proving the “very high” or “very low” value of the property at issue.

Disguised transaction prices can generally be traced through a vertical comparison between the enterprise’s buy-in price and its sell-out price, as well as a horizontal comparison between the price of the property at issue and the then-current open market price. As for the former comparison with respect to real property used for some time before it is sold, depreciation analysis is usually conducted based on the accounting rules at the selling point in order to calculate its net value. In this circumstance, if the enterprise sells the property at a price remarkably lower than the net value, it is transferring the property at a manifestly unreasonable price. As another example, when an enterprise sells an investment, an analysis can be conducted through a vertical comparison between (i) the price paid when the enterprise bought the shares and the net value of the investment company at that time and (ii) the price received when the enterprise sells the shares and the current net value of the investment company. If the shares are sold at a lower price than the then-current buy-in price while the net value of the investment company has increased, the enterprise is likely transferring the shares at an manifestly unreasonable price. Although the latter comparison is easier to understand and master, it must be stressed that the open market price used for the horizontal comparison should be the price on the date and at the place of the transaction.

When conditions allow, an asset valuation company can also be retained to evaluate the buy-in or sell-out property. The benchmark should be the transaction day or the property/interest delivery day. Generally speaking, if an enterprise buys a certain property or interest, it can afford to evaluate it.

3. Decision on Whether or Not a Transaction Price is “Manifestly Unreasonable”

The Enterprise Bankruptcy Law does not tell us how much of a price deviation makes a price “manifestly unreasonable”. Nevertheless, Article 17 of the Interpretations of the Supreme Court on Certain Issues Concerning the Application of the P.R.C. Contract Law (II) can be used as a reference, since they both regulate transactions conducted at manifestly unreasonable prices between civil subjects for the purpose of preserving creditors’ rights.

Said Article 17 provides as follows: Whether a price is "manifestly unreasonably low" as stated in Article 74 of the Contract Law, shall be determined by the court from the point of view of a reasonable business operator at the location of the transaction, with reference to the guiding price of the pricing bureau or the market price at the place and time of the transaction, after a comprehensive consideration of other relevant factors.”

Where a transfer price fails to reach 70 percent of the guiding price or market price at the place and time of the transaction, the price is generally considered manifestly and unreasonably low. Where a transfer price is 30 percent higher than the guiding price or the market price at the place and time of the transaction, the price is generally considered manifestly and unreasonably high.

In other words, when the transaction price deviates more than 30% up or down, the transaction is considered to have been conducted at a “manifestly unreasonable” price.

4. Revocation of Transactions involving “Manifestly Unreasonable Prices” by Administrators or Creditors

According to the Enterprise Bankruptcy Law, if the debtor's property is transferred at a manifestly unreasonably low price within one year before the People's Court accepts the application for bankruptcy, the administrator shall be entitled to motion the People's Court to revoke the transaction.

Even if the administrator does not exercise the right of revocation, the creditor can exercise it. This right is based on Article 74 of the Contract Law rather than on the Enterprise Bankruptcy Law. Before the administrator commences the bankruptcy liquidation of the enterprise, creditors are not in a position to know of the existence of such transactions. As the liquidation proceeds, creditors will be able to learn of these circumstances and motion for the revocation of the transactions when the administrator does not exercise its right of revocation