On 27 August 2006, the PRC National People’s Congress passed a new Enterprise Insolvency Law (the “Law”) after more than a decade’s preparation and debate. The Law, which will become effective on 1 June 2007, introduces a formal insolvency process applying to a wide range of legal entities. The Law only contains general principles which in practice are unlikely to provide sufficient protection to creditors’ interests.

Scope of application

The Law unifies separate insolvency regimes currently applying to different types of enterprise. Chinese insolvency law is a patchwork of legislation consisting mainly of a law governing the insolvency of state-owned enterprises “SOEs”, a 2002 Supreme People’s Court judicial interpretation extending to non-SOEs the application of the law governing the insolvency of SOEs, a few provisions in the Civil Procedure Law and corresponding Supreme People’s Court judicial interpretations.

The new legislation applies to any “enterprise with legal person status”, including foreign-invested enterprises “FIEs” with legal person status. It does not apply to individuals, and non-corporate partnerships. The Law does not apply to companies established outside the PRC, nor does it apply in the Hong Kong or Macau Special Administrative Regions. It does, however, apply outside the PRC in the context of cross-border insolvencies.

Cross-border insolvencies

The new regime purports to have universal implications, for it includes provisions applying to both “outbound” and “inbound” cross-border insolvencies. In the case of “outbound” cross-border insolvency cases, the Law indicates that in insolvency proceedings initiated in the PRC, the scope of the insolvent estate can be extended to the assets of the debtor located outside of the PRC.

As for “inbound” cross-border insolvency cases, the Law sets out onerous conditions that will make it extremely difficult for a foreign administrator to obtain recognition and enforcement in China of an insolvency judgment or ruling made by a foreign court. The new legislation provides that any insolvency proceedings commenced outside the PRC will only be binding on the assets of the debtor in the PRC if the People’s Court determines that all six following conditions are satisfied:

  • there are relevant treaties or reciprocal relations between such country and the PRC;
  • the foreign court’s decision does not violate the “fundamental principles” of the laws of the PRC;
  • the foreign court’s decision is not detrimental to the sovereignty of the PRC;
  • the foreign court’s decision is not detrimental to the national security of the PRC;
  • the foreign court’s decision is not detrimental to the “social public interests” of the PRC; and
  • the foreign court’s decision is not prejudicial to the rights and interests of the creditors in the PRC.

It remains to be seen to what extent the People’s Courts will rely on these conditions to exert discretion as to allowing a foreign administrator to secure an insolvent debtor’s assets in China and repatriate such assets (or the proceeds from the sale of such assets) back home.

Eligibility for insolvency

Article 2 of the Law sets out the general grounds for debtors to lodge insolvency, reorganisation or debt composition applications with the People’s Courts. The debtor must satisfy the following “cumulative insolvency test”:

  • the debtor is unable to discharge its debts as they fall due; and
  • the debtor is “obviously unable to pay its debts”, or its assets are insufficient to discharge its debts in full.

There are certain specific circumstances where the cumulative test does not apply. First, a creditors lodging an insolvency or reorganisation application with the People’s Court does not have to demonstrate that the debtor satisfies the cumulative test: article 7 of the Law only requires the creditor to demonstrate the debtor’s cash flow insolvency, i.e. the debtor’s inability to discharge its debts as they fall due. Another situation where the cumulative test does not apply is when a reorganisation application is lodged with the People’s Court: under article 2(2), the applicant (whether a creditor or the debtor) can simply demonstrate that there is an “obvious possibility the debtor will lose the ability to pay debts”.

Acceptance by the People’s Court

Prior government approval is no longer required before an insolvency application can be lodged with the People’s Court. This contrasts with the 1986 Insolvency Law, which subjected the initiation of any insolvency proceedings to government approval. Although the new regime confers considerable responsibilities to local People’s Courts, it is expected that local People’s Courts will be reluctant to accept an insolvency application without strong local government support.

Insolvency applications must be lodged with the People’s Court of the place of the debtor’s domicile. After acceptance by the Court of an insolvency application, any settlement of debts between the debtor and individual creditors is invalid. Continuing legal proceedings (including arbitration) are suspended and any new court proceeding must be brought in the People’s Court which has accepted the insolvency application.

Management of the debtor’s estate

The Law introduces the role of administrator, who is appointed by, and accountable to, the People’s Court. The administrator is responsible for managing the debtor’s assets during the insolvency (and, in some circumstances, the reorganisation). Lawyers, accountants and other qualified insolvency professionals can be appointed as administrators. The Law provides for creditors’ meetings to be held and for the election of a creditors’ committee to assist the administrator. Employees and trade unions are entitled to send representatives to attend the creditors’ meeting.

Claw-back provisions

The Law entitles the administrator to apply to the People’s Court to rescind certain acts that have occurred before the People Court’s acceptance of the insolvency application. Recovered property forms part of the assets available for distribution. The following acts of an insolvent debtor are invalid when they occur in the year preceding the acceptance of the insolvency application by the People’s Court:

  • gratuitous transfer of property;
  • sale of property at below market price;
  • provision of security to unsecured creditors;
  • prepayment of debts that are not due; and
  • waiver of claims.

The Law also gives the administrator the authority to apply to the People’s Court to recover amounts paid by the debtor in payment of debts that have fallen due if such payments have occurred in the six months preceding the acceptance of the insolvency application by the People’s Court. 

After the insolvency application has been accepted by the People’s Court, the administrator can decide whether to continue or terminate any of the debtor’s continuing contracts. The administrator must notify the counterparty of his decision within two months of the court’s acceptance of the insolvency application. If the administrator remains silent and fails to send a notice to the counterparty by the prescribed deadline, the administrator is deemed to have terminated the contract. If the administrator decides to continue a contract, the Law allows the counterparty to require the administrator to provide security in order to mitigate the counterparty’s risk of continuing a contract with an insolvent company.

Insolvency distribution

The distribution of the proceeds of the insolvent debtor’s assets is settled in the following order:

  • insolvency expenses and debts for the common benefit;secured claims; labour claims;
  • taxes; and
  • unsecured claims.

The new regime provides secured creditors with a higher priority than staff and workers in the insolvency distribution. This increases the value of secured claims, especially in cases where insolvent debtors have a significant number of employees.

Reorganisation procedures

After the People’s Court has accepted an insolvency application lodged by a creditor, but before the People’s Court declares the debtor insolvent, the creditor, the debtor, or an investor holding more than 10 per cent of the debtor’s registered capital, can apply to the People’s Court for reorganisation. This procedure is also available to the debtor before any insolvency application is lodged with a People’s Court.

The debtor has six months (with the possibility of a three-month extension) from the start of the “reorganisation period” to submit a draft “reorganisation plan” to the People’s Court. To become effective, the plan must be approved by a majority of creditors in each “voting group” (i.e. secured creditors, employees, tax creditors and unsecured creditors), representing at least two-thirds of the debt.

During the reorganisation period, the debtor remains technically able to manage its property and business. The Law clarifies under which circumstances certain acts can be performed during the reorganisation period. For instance, during this period, the debtor can borrow funds for continuing business operations, and it can provide security for such borrowings. Secured creditors cannot exercise security rights over the debtor’s property, unless the secured creditor demonstrates to the People’s Court that there is a possibility that the secured property will lose significant value. The debtor’s senior management staff cannot transfer their interests in the debtor’s registered capital to any third party without the consent of the People’s Court.

Conciliation procedures

Chapter 9 introduces conciliation procedures available to the debtor. After the People’s Court has accepted an insolvency application, but before the People’s Court declares the debtor insolvent, the debtor can apply to the People’s Court for the conciliation (or “debt composition”) of its debt. This procedure is also available to the debtor before any insolvency application is lodged with a People’s Court.

When applying for conciliation, the debtor and unsecured creditors must provide the People’s Court with a draft conciliation agreement, pursuant to which the debtor and its unsecured creditors reach a compromise over the reduction, discharge or postponement of the debtor’s obligations.

After a conciliation application has been lodged with the People’s Court, secured creditors’ rights over the debtor’s property are suspended until the People’s Court has rendered a decision on the conciliation application. The Law does not indicate any time limit for the Court to render a decision.

After the People’s Court has reviewed the agreement and accepted the conciliation application, it will convene a meeting of unsecured creditors. The Law does not indicate any time limit for convening the meeting but the conciliation agreement must be endorsed by a majority of unsecured creditors attending a meeting convened by the People’s Court and representing two thirds of the debtors’ total unsecured debt.

Conclusion

The new legislation represents a major step in creating a uniform insolvency regime but the general principles it introduces must be supplemented by judicial interpretation in order to be put into practice. Foreign creditors seeking recovery against overseas debtors’ assets located in China should beware. The Law subjects the recognition of “inbound” cross-border insolvency cases to conditions so onerous that it will remain extremely difficult to obtain enforcement in China of an insolvency judgment or ruling made by a foreign court.